Theme 3.4: Market Structures

Question 1

What are the four key characteristics of a market structure?

Answer 1

1. Number of firms
2. Product differentiation
3. Barriers to entry
4. Information

Question 2

Give the four assumptions and implications of a firm in a perfect competition market structure

Answer 2

1. Many insignificant firms: firms cannot influence industry supply, low concentration ratio, act independently
2. Homogeneous goods: firms cannot differentiate their goods, and all are very strong substitutes, so the firms are price takers
3. No barriers to entry or exit: firms can easily join or leave the industry, so if abnormal profits are being made, new entrants will join, so only normal profits will be earned in the long run
4. Perfect Information: Little to no patenting or copyrighting, no trade secrets
   (5. SR profit maximisation: Firms operate at MR = MC)

Question 3

Give three examples of monopolistic competition

Answer 3

• Sandwich bars
• Takeaway restaurants
• Hairdressers
• Children’s nurseries
• Care homes
• Hotels
• Coach companies

Question 3

Give the four assumptions and implications of a firm in a monopolistic competition market structure

Answer 3

1. Many insignificant firms: firms cannot influence industry supply, low concentration ratio, act independently
2. Differentiated goods: firms have some degree of price setting ability, but there are relatively strong substitutes, so demand will be relativel elastic, but there will be some brand loyalty
3. Low barriers to entry or exit: firms can easily join or leave the industry, so if abnormal profits are being made, new entrants will join, so only normal profits will be earned in the long run
4. Imperfect Information: Buyers and sellers do not have complete market information
   (5. SR profit maximisation: Firms operate at MR = MC)

Question 3

What is the order that curves should be drawn in in a LR monopolistic competition diagram?

Answer 3

AC
MC
AR at a tangent to AC
P1Q1 equilibrim at AR/AC intersection
MR passing through MC at equilibrium point

Question 4

Give the four assumptions and implications of a firm in an oligopoly market structure

Answer 4

1. A few dominant firms: high concentration ratio, limited consumer choice
2. Differentiated goods: firms have price setting power, and they are able to compete on non-price factors as well as price
3. High barriers to entry or exit: new firms find it difficult to enter the industry, so supernormal profits can be earned in the long run
4. Firms are interdependent: actions of one firm affect the others in the industry, so firms act strategically, reacting to rival firm decision and anticipating their future actions (if one firm gains market share, it is at the exapense of other firms)
   (5. SR profit maximisation: Firms operate at MR = MC)

Question 5

What does the kinked demand curve implicate about pricing in oligopolies?

Answer 5

The interdependent nature of oligopolies: elasticity of demand faced is different depending on whether a firm raises or lowers its price (this is partially due to the possible reactions of other firms)
Price rigidity: changes to the marginal cost do not lead to a change in the equilibrium price (unless the change in MC is very high), and the different elasticities mean there is little incentive to depart from the ‘status quo’

Question 6

Describe predatory pricing

Answer 6

Pricing at a level below the firm’s own cost with the aim of forcing a competitor out of business
Potential of success depends on having greater ability to withstand SR losses than the competitor (more funds)
Success = potential for greater profits in the long run due to less competition

Question 7

Evaluate predatory pricing

Answer 7

It is illegal in the UK, so firms might be put off from conducting this strategy (though it’s difficult for regulators to prove)
Depends on the relative risk/reward of the policy - if the chance of being caught is high, and the punishment is high, the business will be less likely to conduct predatory pricing
Firms will incur losses - requires substantial cash reserves or access to credit to be a viable strategy

Question 8

Describe limit pricing

Answer 8

Similar to predatory pricing, but designed to prevent firms from entering a market
Firms set their price below the AC of potential competitors
Possible to still make profit if incumbent benefits from high EoS
Success = no obvious end to this pricing policy

Question 9

Evaluate limit pricing

Answer 9

Firms must forgo significant profits in the short run to pusue this
Firms may not have clear information on the entrants’ ACs, so struggle to determine the necessary price to be effective

Question 10

Describe price leadership

Answer 10

A situation where prices and price changes established by a dominant firm are accepted by others and which other firms in the industry adopt and follow
Can be a form of tacit collusion if all industry prices tend towards a higher price
e.g. price matching by supermarkets could be seen as tacit collusion

Question 11

Evaluate price leadership

Answer 11

Regulators might intervene if the pricing actions of firms in an industry are against the consumer interest
However, tacit collusion is very difficult to prove

Question 12

Describe the conditions for price wars to break out

Answer 12

Tends to occur in industries were non-price competition is weak
Could be a result of price based competition or predatory pricing
More likely in industries where goods are weakly branded

Question 13

Evaluate price wars

Answer 13

Firms generally attempt to avoid price wars due to the impact on revenue
Kinked demand cure suggests price rigidity as firms lack the incentive to change their price, so firms might be more likely to engage in non-price competition

Question 14

List the possible forms of non-price competition

Answer 14

• Marketing
• Innovation
• Loyalty cards
• After sales surveys
• Opening hours
• Delivery
• Customer service
• Contractual arrangements

Question 15

Explain marketing non-price competition

Answer 15

Advertising, branding and wider marketing
Successful marketing increases demand (shifts AR & MR right)
Strong brands make product more price inelastic
Is it a zero-sum gain? Will marketing efforts of competitors cancel out any advantage?

Question 16

Explain quality non-price competition

Answer 16

Innovation: creating new and improved products
Innovation + patenting may reinforce market power
Longer term strategy (requires patience)
First mover advantage

Question 17

Explain mergers and acquisitions non-price competition

Answer 17

Horizontal mergers with other firms in the industry can effectively increase market power
Can be a useful way to counter a dominant firm in the industry

Question 18

Explain customer loyalty non-price competition

Answer 18

Good customer service increases demand (shifts AR & MR right)
Opening hours
Customer experience, such as John Lewis / Waitrose

Question 19

Give the general evaluation points for non-price competition

Answer 19

Firms may use a combination of strategies at any one point in time
Strategies may change over time
Firm’s strategies may not be clear to the outside world

Question 20

Describe collusion

Answer 20

Any form of agreement between firms to avoid competition with each other
Firms have the incentive to collude as it helps them to maximise profit
Firms act like one decision maker (like a monopoly)
Collusion can be overt or tacit: overt, anti-competitive collusion is illegal

Question 21

Describe overt collusion

Answer 21

Overt: spoken, open or traceable
Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry
Price fixing represents an attempt by suppliers to control supply and fix prices close to a monopoly’s desired price

Question 22

Describe tacit collusion

Answer 22

Unspoken actions between oligopolistic firms that are likely to minimise a competitive response. For example, to firms may decide to avoid price cutting or not attacking each other’s market share

Question 23

Describe cartels

Answer 23

Agreements between 2 or more firms not to compete with each other Can be an agreement to fix prices or to reduce production levels

Question 24

Give a real world example of a cartel

Answer 24

OPEC: 14 oil producing nations, each has an oil production quota which they agree not to exceed

Question 25

What conditions are cartels more likely to form under

Answer 25

The smaller number of firms, the more likely an agreement can be made and held to More likely in stable, mature industries than rapidly evolving industries High barriers to entry: resulting supernormal profit will attract new entrants, so high barriers to entry restrict their ability to join the market Where there is a higher level of trust between colluding firms in general

Question 26

How does a game theory payoff matrix show how collusion works?

Answer 26

1. Without collusion, the firms would set a low price 2. Firms have an incentive to collude and raise prices to maximise their revenue 3. Collusion is likely to produce an unstable equilibrium, where firms have an incentive to 'cheat'

Question 27

Evaluate cartels and collusion

Answer 27

Producers may have an incentive to 'cheat' the agreement and produce more or lower their prices Effective regulation may lead to exposure or illegal price-fixing Indemnity guarantees by regulators may encourage exposure of price-fixing by whistle-blowing firms

Question 28

Give the four assumptions and implications of a firm in an oligopoly market structure

Answer 28

1. One (dominant) firm: The level of industry supply is determined solely by the monopoly firm, the firm is a price setter 2. High barriers to entry: difficult for new firms to join, so supernormal profits can be achieved in the long run 3. Differentiated products: the firm is a price setter, alternative products are weak substitutes 4. Imperfect information: new firms may lack know-how to compete effectively (also barrier to entry), greater potential for the firm to price discriminate (5. SR profit maximisation: Firms operate at MR = MC)

Question 29

Difference between monopoly and monopoly power

Answer 29

Monopoly is a precise market structure Monopoly power describes factors that enable firms to be price setters (this can also happen in more competitive markets, like an oligopoly

Question 30

Give the two sources of monopoly power

Answer 30

1. Barriers to entry 2. Product differentiation and near competitors

Question 31

Explain how barriers to entry are a source of monopoly power

Answer 31

Legal barriers: patents, licensing Sunk costs: industry-specific capital inputs with little to no resale value Anti-competitive practices: e.g. limit pricing Marketing barriers: cars, cosmetics, existing branding can make it difficult for firms to create their own recognisable brand Scale economies: new entrants may struggle to compete with a firm benefitting from EoS International trade restrictions: tariffs / quotas may create national monopolies Greater barriers to entry = stronger monopoly power

Question 32

Explain how product differentiation is a source of monopoly power

Answer 32

Products that are clearly differentiated from rivals means consumers may rely more heavily on it Electricity: batteries, gas, oil are poor substitutes Southampton-London train route is local / regional monopoly power

Question 33

Describe a natural monopoly

Answer 33

Where industry EoS are so large that one producer will always achieve lower costs than a situation with two or more firms. If there were multiple firms, the average costs of each smaller firm would be higher than the natural monopoly's: more likely in an industry with significant fixed costs and low marginal costs It is more efficient for a natural monopoly industry to operate with one firm rather than several, as several would lead to a waste of resources

Question 34

Give two examples of real world natural monopolies

Answer 34

Gas, electricity or water have huge costs of building and maintaining nationwide networks of cables and pipes Channel tunnel: no point in having a second tunnel

Question 35

Give the evaluation of natural monopolies

Answer 35

'Competition' has been created in utility industries through government regulation An industry that is a natural monopoly may become competitive over time, if the market structure changes Natural monopolies still face competition, e.g. the channel tunnel faces competition from ferries and flights

Question 36

How does a natural monopoly diagram differ from a typical cost and revenue diagram?

Answer 36

The MC / AC intersection is to the right of the MR / AR curve

Question 37

Advantages of monopolies for the firm itself

Answer 37

Economies of scale: Lower costs due to their scale, lower costs = higher profits Pricing power: strong pricing power and lack of substitutes means that monopolies are likely to command large profit margins Fewer competitors: lack of competition means that monopolies do not have as significant competitive pressures (less need to advertise or innovate)

Question 38

Disadvantages of monopolies for the firm itself

Answer 38

Regulatory scrutiny: monopolies can be investigated by regulators if they are unfairly exploiting consumers (CMA investigating in the UK) Threats from outside of the industry: if monopolies fail to innovate over time, they may lose out to more dynamic firms in other industries

Question 39

Advantages of monopolies for consumers

Answer 39

Economies of scale: lower costs may be passed onto consumers as lower prices, especially in natural monopoly industries Innovation from supernormal profit: reinvested profit could lead to dynamic efficiency Stability for consumers and businesses: monopolists can plan for long term industry development

Question 40

Disadvantages of monopolies for consumers

Answer 40

Higher prices and lower output: consumers may pay higher prices than a competitive equilibrium, so some consumers are 'priced out' Lack of incentive to be efficient: allocatively inefficient, pricing above marginal cost, X-inefficient, operating above its AC curve, dynamically inefficient, lack of competitive incentive to innovate

Question 41

Advantages of monopolies for employees

Answer 41

Better rates of pay than smaller firms Better for job security Career progression opportunities

Question 42

Disadvantages of monopolies for employees

Answer 42

Workers may lack alternative employers in the industry, so they have a weak bargaining power against the monopoly firm Jobs may not be secure if large firms can replace a worker with machinery

Question 43

Advantages of monopolies for suppliers

Answer 43

Supplier might enjoy regular orders which could be a significant part of their revenue, which is more stable than many small orders Supplying to a major firm may provide a good image for the business

Question 44

Disadvantages of monopolies for suppliers

Answer 44

Suppliers have a weak bargaining position, and are forced to accept lower prices over time Could become over dependent on the demand from a monopoly firm

Question 45

Problems with the monopoly 'model'

Answer 45

Monopolies are not always bad: may be desirable in some cases but may need strong regulation Monopolies do not have to be big: many examples of local monopolies Some industries are ‘natural’ monopolies, which are more efficient to have one firm than many firms

Question 46

Define price discrimination

Answer 46

Charging different groups of consumers different prices for the same good or service

Question 47

Give the conditions for price discrimination

Answer 47

Price-setting power in at least one market Different price elasticities of demand of at least two consumer groups Have information about consumer preferences: the firm should be able to identify consumers in each group, and set different prices for the different groups Low or no market arbitrage or market seepage: the firm must prevent consumers in one group selling to consumers in the other

Question 48

What are the different degrees of price discrimination?

Answer 48

(1st degree price discrimination: Perfect segmentation with every customer charged their “willingness to pay”) (2nd degree price discrimination: Differing quantities) ** 3rd degree price discrimination: ** Market segmentation due to different elasticities of demand

Question 49

Describe third degree market separation

Answer 49

Firms seek to segment the market into two or more groups Firms maximise profits in each sub-market using their differing elasticities of demand: lower price for groups with elastic demand and higher price for groups with inelastic demand Requires inability to resell good (or prevention of doing so)

Question 50

Give some real world examples of 3rd degree market separation

Answer 50

Discounts to senior citizens Student discounts Gender pricing in bars / nightclubs Price of petrol in the city vs motorways

Question 51

Give the advantages of price discrimination

Answer 51

Some consumers are 'priced in', who might not have otherwise been able to afford the product, e.g. cheaper anti-viral drugs for developing countries Higher output than under a single price Profits may finance research and development projects Profits may help to cross-subsidise other activities

Question 52

Give the disadvantages of price discrimination

Answer 52

Some customers pay higher prices than under normal market equilibrium Fairness issues No guarantee that increased profits earned will actually lead to investment and innovation Producers could lose revenue/profit if their information about consumers is imperfect

Question 53

What is a contestable market?

Answer 53

A market with low barriers to entry / exit

Question 54

What are the three main categories of barriers to entry?

Answer 54

1. Illegal anti-competitive practices (limit / predatory pricing) 2. The nature of the industry (capital costs, sunk costs, EoS) 3. Those imposed by authorities (legal barriers: patenting, licensing)

Question 55

What is the main assumption of contestable markets?

Answer 55

Inability for firms to make abnormal profits in the long run

Question 56

Where do firms in contestable markets normally choose to operate? Why?

Answer 56

AR = AC To avoid losing market share or to avoid hit-and-run tactics

Question 57

What are the three main ways contestability may 'organically' occur in a market?

Answer 57

1. Entrepreneurial zeal 2. Advances in technology 3. Economic cycle

Question 58

How does entrepreneurial zeal lead to greater market contestability?

Answer 58

Entrepreneurs are risk-takers that are looking for ways of profiting by breaking existing market structures e.g. Metro bank challenging dominance of major UK banks

Question 59

How do advances in technology lead to greater contestability?

Answer 59

Internet: new entry point in many markets, reduces costs of joining an industry (less need for chain shops), improved information for consumers and firms about their suppliers and components Advances may reduce the minimum efficient scale of production

Question 60

How does the economic cycle lead to greater contestability?

Answer 60

A recession can open up markets to new businesses e.g. The recession of 2008/09 led to an increase in market share for discount food retailers like Aldi and Lidl – taking away market share from dominant food retailers

Question 61

What are four policies that can be used to improve the contestability of a market?

Answer 61

1. Privatisation and deregulation 2. Regulation 3. Improving access to selling platforms 4. European integration

Question 62

How does privatisation and deregulation lead to greater contestability?

Answer 62

Privatisation creates a profit motive for a company, which encourages greater efficiency When privatisation occurs alongside deregulation, it can open up the market to competition, e.g. rail and utility companies in 1980's

Question 63

How does regulation lead to greater contestability?

Answer 63

Firms can be forced to allow others to use their network Without this, the market might become a 'natural monopoly' e.g. telecomms, gas, electricity

Question 64

How does improved access to selling platforms lead to greater contestability?

Answer 64

E.g. Access to flight routes for air travel operators, may require regulation if the market does not provide competition Government could remove statutory licensing that prevents other firms from competing or force private companies to offer routes to more suppliers

Question 65

How does European integration lead to greater contestability?

Answer 65

Membership of the EU includes being part of a free trade area No trade barriers between EU economies increases size of markets – greater number of suppliers that can compete in any one market, and allows EoS to be fully exploited

Question 66

What are the two broad types of efficiency?

Answer 66

** Static efficiency**: the efficiency of an industry at one point in time ** Dynamic efficiency**: the efficiency of an industry over a period of time

Question 67

Describe allocative efficiency

Answer 67

How efficiently resources are allocated Achieved when P = MC / AR = MC The value consumers place on a good or service equals the cost of the resources used up in production A type of static efficiency

Question 68

Describe productive efficiency

Answer 68

Is the product being produced as cheaply as possible? AC at its lowest / AC = MC A type of static efficiency

Question 69

Describe dynamic efficiency

Answer 69

When resources are used more efficiently over time: lower costs / better products Two main requirements: 1. Means: supernormal profits for R&D 2. Incentive: the element of competition to incentivise the improvement of products

Question 70

Describe X-inefficiency

Answer 70

When a firm is not producing at the lowest possible cost for a given level of output Managerial inefficiencies: bloated administrative costs Other factors raising costs, such as trade unions raising workers' wages above the market rate / environmental regulation causing costs to increase

Question 71

Determine the efficiency of firms in a LR perfect competition market

Answer 71

Allocatively efficient: MR = MC, P = MC, AR = MC Productively efficient: operating at lowest point on AC curve Dynamically inefficient: Normal profits in LR means there are no funds for innovation, homogeneous goods means there is no incentive to innovate X-efficient: X-inefficient firms will have to lower their costs or leave

Question 72

Determine the efficiency of firms in a LR monopolistic competition market

Answer 72

Allocatively inefficient: MR = MC, P > MC Productively inefficient: not operating at lowest point on AC curve Dynamically inefficient: Normal profits in LR means there are no funds for innovation, competitive incentive to innovate X-efficient: X-inefficient firms will have to lower their costs or leave

Question 73

Determine the efficiency of firms in a LR oligopolistic market

Answer 73

Allocatively inefficient: MR = MC, P > MC Productively inefficient: not operating at lowest point on AC curve Dynamically efficient: supernormal profits are possible in the LR, competitive incentive to innovate (unless colluding) X-efficient?: supernormal profits means that X-inefficiencies are possible, but competition means that firms need to keep their costs low

Question 74

Determine the efficiency of firms in a LR monopoly market

Answer 74

Allocatively inefficient: MR = MC, P > MC Productively inefficient: not operating at lowest point on AC curve Dynamically efficient?: supernormal profits are possible in the LR, lack of competitive incentive to innovate X-efficient?: supernormal profits means that X-inefficiencies are possible, lack of competition means firms can get away with poor control of costs and stay in business

Question 75

Which industries are likely to achieve static efficiency?

Answer 75

Perfectly competitive industries: this is good for consumers via prices that are at or close to the cost of production Monopoly industries are unlikely to achieve static efficiency: consumers are likely to pay prices in excess to the cost of production

Question 76

Which industries are likely to achieve dynamic efficiency?

Answer 76

Oligopolies and monopolies: they tend to make abnormal profits, and have a greater potential to invest and therefore achieve dynamic efficiency But, monopoly firms lack competition, so may lack the incentive to invest their profits As perfectly competitive firms cannot earn abnormal profits in the long run, they don't make the same dynamic gains that monopoly and oligopoly industries have the potential to

Question 77

Why is efficiency a trade off?

Answer 77

Unlikely that both dynamic and static efficiency can be achieved simultaneously Achieving static efficiency requires making an industry more competitive through the reduction or removal of barriers to entry, which would reduce firms long run ability to make abnormal profits, so would compromise their investment capabilities

Question 78

Describe a monopsony

Answer 78

There is only one buyer in the market (more loosely: one dominant buyer) Sellers do not have viable alternative buyers The buyer profit maximises, so aims to minimise their costs by paying the suppliers the lowest possible prices The firm has buying power, meaning they can negotiate lower prices

Question 79

Give real world examples of monoposony markets

Answer 79

NHS: accounts for >90% of healthcare equipment purchased in the UK Tesco and other supermarkets are able to drive down the price paid to dairy farmers for milk British sugar buys almost the entire sugar beet crop in the UK each year Amazon's buying power in the retail book market: gets a better price than other booksellers, which gives it a significant competitive advantage

Question 80

Advantages of monopsonies

Answer 80

Lower buying costs = lower prices, greater value for money for consumers Lower costs = greater profits which could lead to greater innovation (dynamic efficiency) Could counter-weight a dominant seller

Question 81

Disadvantages of monopsonies

Answer 81

Suppliers could be squeezes out of business, which could create a problem for the future supply Monopsony's supply relations could act as a barrier to entry for new entrants who cannot easily access suppliers of materials Competitive gains to a monopsonist from lower supplier prices may reinforce a monopoly position in their dupply to customers further down the production chain