Topic 6 - Market Structures Flashcards
What are the types of efficiency ?
Dynamic efficiency
Static efficiency
What is dynamic efficiency ?
Dynamic efficiency refers to how efficient a system is over time. It looks at how productivity changes over time.
For dynamic efficiency to be achieved, normally some supernormal profits must be made in the long run. This is because firms need to reinvest profits.
What is static efficiency?
Static efficiency refers to the efficiency at a point in time.
It is made up of allocative and productive efficiency.
A firm can be statically efficient without making supernormal profits.
What is X-inefficiency ?
X-inefficiency happens when monopolies do not feel the need to reinvest their profits to improve their efficiency.
So, they do not produce at their lowest possible cost
What are the causes of X-inefficiency ?
Inefficient use of factors of production.
Overpaying for factors of production.
What conditions are needed for dynamic efficiency to occur ?
Supernormal profits so reinvestment in RnD can occur to improve factors of production
Dynamic efficiency is changed by factors that affect productivity and improve factors of production.
E.g investment in human capital might increase the output per worker over time. This is an increase in dynamic efficiency.
Technological change can lead to new processes that are more efficient.
What are the conditions for productive efficiency?
Productive efficiency means firms are producing at the minimum possible cost.
So they must be producing on the lowest point of their average cost curve.
For productive efficiency, marginal cost (MC) must equal average cost (AC).
What are the conditions for allocative efficiency?
Allocative efficiency happens when the benefit gained from the extra unit of the good is equal to the price of it.
So allocative efficiency happens when the marginal utility the consumer gains is equal to the price.
Or when the marginal cost of producing the good is equal to the price.
Allocative efficiency can also be shown by an economy operating at a point on (but not inside) its PPF.
How does the characteristics of a monopoly dictate output, price and the distribution of surplus and welfare ?
In a free market a monopoly will look to maximise profits and without competition can do that at the point where marginal costs = marginal revenue. This is at a higher price and lower quantity than there would be in a competitive market.
Consumer surplus is lower than in a perfectly competitive market.
But if there are few barriers to entry, then there is an incentive to enter the market and the price could fall. Competitors could reduce prices or innovate to produce a cheaper or better product, which would be good for consumers.
How does the characteristics of a monopolist dictate output, price and the distribution of surplus and welfare ?
Monopolistic competition is where firms are selling unique products but are competing over the same customers.
Each firm has a degree of monopoly power which they earn through providing differentiated products and building their brand.
With differentiated products, consumers face more choice potentially satisfying more wants and needs.
How does the characteristics of a competitive oligopoly dictate output, price and the distribution of surplus and welfare ?
If an oligopoly is competitive firms will compete somewhat on price and product.
The firms are incentivised to invest in research and development which leads to continuous innovation in both product and production further lowering prices and improving quality.
The mobile phone industry is a prime example (Apple, Samsung etc). A small number of large competitive firms who continually work to offer the best product.
In these markets, quantity is higher and price lower than in a monopoly. But consumer surplus is usually lower than in a perfectly competitive market.
In the long-run, the innovation enabled by supernormal profits may make welfare higher, because the market is more dynamically efficient.
How does the characteristics of a uncompetitive oligopoly dictate output, price and the distribution of surplus and welfare ?
Oligopolies can also be uncompetitive and act like monopolies. - With a small number of firms in the market it is easier to collaborate and collude either explicitly or tacitly. When they collude, firms set prices and output so that the firms share the monopoly profit.
To the consumer, the market can be indistinguishable from a monopoly with higher prices, lower quantity therefore lower surplus and welfare compared to a perfectly competitive market.
How does the characteristics of a natural monopoly dictate output, price and the distribution of surplus and welfare ?
Natural monopolies are markets where it is efficient to have either only one provider or one major provider. These are usually markets where there are disproportionately high fixed costs leading to significant economies of scale.
The incumbent in a natural monopoly is at a significant advantage over smaller competitors and potential entrants due to their much lower average costs due to economies of scale.
Because of this, the threat of competition is weak. If competitors entered, because firms would all have higher costs, this may actually be bad for consumers. Prices are higher and consumer surplus lower at lower quantities of output.
How does the characteristics of a perfect competition dictate output, price and the distribution of surplus and welfare ?
Perfect competition is seen as the ideal situation for consumers, at least in the short run.
In perfect competition, no supplier can affect the market price and market quantity of the good or services they produce.
There are no barriers to entry or exit. Every consumer that can pay the market price is able to consume the good or service.
In which market structure is the threat of competition weakest?
Natural monopoly
How does X-inefficiency happen in a monopoly market ?
X-inefficiency happens when monopolies do not feel the need to reinvest their profits to improve their efficiency. This can happen if a business overpays for factors of production. Manchester United paid Alexis Sanchez £26 million per year for his labour.
What are the characteristics of perfect competition?
Lots of firms produce identical (homogenous) products.
Many buyers and many sellers.
Sellers and buyers have perfect and relevant information to make rational decisions.
Firms can enter and leave the market without restrictions (no barriers to entry or exit).
Firms aim to maximise profit.
How is the market price determined in a perfectly competitive market ?
The market price is determined solely by supply and demand in the entire market.
A perfectly competitive firm must be a very small player in the overall market so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
So, firms are price takers.
Where is the allocative efficient point in perfect competition?
The demand curve is equal to marginal utility (MU) under perfect competition.
The supply curve is equal to the marginal cost (MC).
So, if the forces of demand and supply determine equilibrium, the equilibrium price and quantity will be where MU=MC.
This is allocatively efficient.
If there are externalities, perfect competition may not be allocatively efficient, if the long run equilibrium is price is equal to the marginal private cost.
Where is the productive efficient point in perfect competition?
Firms in perfect competition are productively efficient, assuming there are no economies of scale.
They will produce where the average cost is minimised because this is the only place normal profit can be made.
But if economies of scale exist, a monopoly could be more efficient than a perfectly competitive industry with many firms
Does dynamic efficiency exist in perfect competition?
Firms do not make supernormal profits in perfect competition.
They may not be able to invest in R&D and in new technologies, so this may not be dynamically efficient
How can perfect competition respond to change ?
Firms are profit maximising where MR = MC and normal profit is being made by producers because AR = AC at this point.
Firms are price takers as they must accept the price reached at the industry equilibrium.
average cost for firms has fallen.
The cost of a space at the market has fallen, for example, meaning AC would fall but MC would not.
Firms are now making supernormal profit in the short-run
Supernormal profits and very low barriers to entry would attract new firms to the market.
This would shift supply to the right and reduce the equilibrium price.
So the supernormal profit is ‘eroded’ away very quickly and firms in the industry return to making normal profit, albeit at a lower price
What would a decrease in demand in a perfectly competitive market lead to ?
A decrease in the equilibrium price
Firms in the market now making a loss
Firms exiting the market, and the supply curve shifting left
The equilibrium price increasing
Firms returning to making normal profit after firms exit
What is dynamic efficiency?
How efficient a firm is over time
Perfect competition is not dynamically efficient, what may this mean for investment ?
there is underinvestment in the market in the long run
Dynamic efficiency requires innovation and research over time, which needs supernormal profits.
Perfectly competitive firms only make normal profit because any abnormal profits would be immediately competed away.
So perfectly competitive firms are not dynamically efficient
Why is supernormal profit an issue for perfect competition?
Firms that are perfectly competitive make no supernormal profit long term.
Any supernormal profits will signal to competing firms to enter the industry and competing away the profits.
As new firms enter the industry, supply shifts right to S1.
Firms must start to produce at their minimum average cost, so only normal profits are made.
Low barriers to entry and perfect information make this possible. But perfect information may not exist in reality. Perfect competition is JUST A MODEL
A perfectly competitive market is one where there are a large number of sellers producing homogeneous goods, there or no barriers to entry or exit, there is perfect information and no buyer/seller can affect market price, what are the nearest example to this ?
Electricity
Farmers markets
How is electricity an example of perfect competition?
Electricity is a homogeneous good. When it is being consumed, there is no way of knowing in which power plant it has been produced or whether it has been produced by gas, coal, solar, wind or hydro power plants.
Over the last decade, households who generate their own electricity (e.g. using solar power), have been able to sell what they don’t use back to the national grid. There are lots of electricity sellers in the market
Price comparison websites make information more widely available and the wholesale price of electricity is available on a public market.
But there are some barriers to entry for a household to make electricity (solar power cells) and sell it to the National Grid
How is a farmers market an example of perfect competition?
At a farmers’ market, there are dozens of farmers from a local areas selling homogenous goods like potatoes and tomatoes.
Information is readily available- walking around a few stalls will give a good idea of price.
There are some barriers to entry, like the cost of a stand and the need for farm equipment.
No market is exactly like perfect competition, but we can use the model of perfect competition to predict what outcomes for consumers and firms will be.
Discuss the extent to which a fish market could be considered to be in perfect competition.
In a fish market, there are very low barriers to entry, many buyers and sellers and good price information for consumers, as well as very similar goods - these are all characteristics of a market in perfect competition.
But goods are similar but not identical and, partly as a result of this, sellers are able to charge different prices to consumers for the same good. This suggests that the price could be above the cost and so it is possible to make supernormal profits in the long-run.
So a fish market could be quite close to perfect competition but not the same. But perfect competition is a very theoretical model with many assumptions.
What are the characteristics of monopolistic competition?
There is product differentiation between many small to medium-sized firms.
E.g Mars bars are not the same as Dairy Milk.
This means that firms in an industry can compete on things other than price (e.g taste of chocolate).
The larger the differences in product, the more inelastic demand is.
There is price and non-price competition.
The barriers to entry are low to medium.
Firms can have some price-setting power and there can be brand loyalty.
What is monopolistic competition like in the short run ?
Each firm has some price-making power in monopolistic competition. This means the demand curve slopes downward.
Firms will try to maximise profits by producing where marginal cost is equal to marginal revenue. This is at a higher price than is allocatively efficient.
Firms make supernormal profits in monopolistic competition.
This model is more similar to the model of monopoly
What is monopolistic competition like in the long run ?
The supernormal profits that firms are earning signals to other firms that they should enter the industry.
There are low barriers to entry, so they can join the industry and compete away the supernormal profits in the long run.
So firms only make normal profit in the long run.
This isn’t allocatively efficient as the price is too high, or productively efficient as they are producing above the minimum average cost.
But, it is more efficient than under a monopoly situation
Can there be dynamic efficiency in monopolistic competition ?
Dynamic efficiency needs firms to make supernormal profits.
Firms in monopolistic competition only make abnormal profits in the short run.
There could be dynamic efficiency if they manage to use non-price competition to maintain supernormal profits.
But this is unlikely because of the lower barriers to entry
What is the price in a monopolistically competitive market like compared to a perfectly competitive market ?
Prices under monopolistic competition tend to be higher than under perfect competition.
Under monopolistic competition, there is product differentiation.
This means that firms can spend money on advertising their product for non-price competition. This increases the overall cost of producing and marketing the product.
Firms in perfect competition would not need advertising because we assume there is perfect information.
Firms in monopolistic competition have decide to limit output to maximise profits.
Why is non-price competition important for firms in monopolistic competition ?
Non-price competition is a way for firms in monopolistic competition to make supernormal profits for a sustained period through generating brand loyalty and giving some price-setting power.
What are examples of non-price competition ?
Marketing
Special offers
Customer service
Quality of good/service
How is marketing a form of non-price competition?
Advertising can allow a firm in a competitive market to create a brand image which will allow them to retain customers and achieve some price-setting power.
This is usually an expensive process.
How is having special offers a form of non-price competition?
Promotions can help to attract customers initially, without having to reduce the market price for all customers.
This may allow firms to retain some price-setting power
How is customer service a form of non-price competition ?
Providing excellent customer service can help to generate brand loyalty and allow a firm to set a higher price than competitors without losing sales.
However, this is likely to cost money and so may have an impact on profit.
How is quality of a good/service a form of non-price competition?
Providing a higher quality service may increase a firm’s costs but can allow them to charge a much higher price and therefore to make supernormal profit for a continued period of time.
Even just the perception of higher quality may be sufficient to charge a higher price!
What are examples of monopolistic competition?
Pubs
Hairdressers
Airlines
How are pubs an example of monopolistic competition?
Most pubs offer a similar service, with similar menus & drinks, but prices can vary across pubs.
Pubs can differentiate themselves on service, atmosphere (like Brewdog), the quality of food (gastropubs) or location (like bars with good views of London).
Consumers can become loyal to a brand over time and keep going back to the same pubs.
They generally provide similar goods and services, but can differentiate their offering to get some degree of monopoly power
How are hairdressers an example of monopolistic competition?
Hairdressers offer essentially the same service but with variations in quality and the price charged.
There can be quite low barriers to entry but brand loyalty and reputation are very important to the success of a business.
Some hairdressers can make significant and sustained profits by charging much higher prices for a superior service.
How are airlines an example of monopolistic competition ?
Airlines operate in a monopolistically competitive market.
They each provide a travel service with a number of firms offering essentially the same service – flying to and from the same countries, often the same cities and sometimes the same airports.
Different companies have different brands - e.g EasyJet’s orange uniforms and planes. Airlines compete on service, reputation and sometimes price.
Price comparison websites like Skyscanner allow customers to compare prices easily.
What are Pepsi, Fanta and Coca-Cola more likely to compete on?
Non-price competition
Distribution
Price competition
Non-price competition
What’s an oligopoly?
an industry which is dominated by a few firms
What are the characteristics of an oligopoly?
A few firms with a high concentration ratio and significant price-setting power.
Supernormal profit in the short-run and long-run.
Barriers to entry are relatively high.
Product differentiation.
Interdependence between firms. But they can often implement collusive strategies.
Oligopoly can be defined through either its conduct (collusive or competitive), or its structure.
In an oligopoly, what does the concentration ratio measure ?
Concentration ratios measure the power of the firms in an oligopoly.
If there are four firms in an oligopoly that take up 76% of the market, then the four-firm concentration ratio is 76%.
In an oligopoly, what does the n-firm concentration ratio measure ?
The n-firm concentration ratio is a measure of market structure. It combines the market share of the top n firms as a % of the total market.
E.g If the top 3 firms control 80% of a market, the 3-firm concentration ratio is 0.8.
How does collusion occur in an oligopoly?
Firms in an oligopoly are interdependent. Their pricing and product strategies depend on the behaviour of the other firms.
The prisoners’ dilemma shows us that firms can receive a greater payoff by colluding.
Firms can agree to raise prices.
In an oligopoly what are the types of collusion?
Formal collusion
Tacit collusion
What is formal collusion?
Formal collusion: a spoken agreement between firms to keep prices high.
What is tacit collusion ?
Tacit collusion: an unspoken agreement between firms. Tacit collusion often works through price leadership. Here, it is in both firms best interest not to change prices
In a non-collusive oligopoly what do for a compete on ?
In a non-collusive oligopoly, firms compete with each other on a number of factors, including price.
Non-collusive oligopolies are a common type of market structure
What would be the obvious differences between a non- collusive and collusive oligopoly?
Non-collusive oligopolies are more likely when we see:
Low entry barriers, a high number of firms, and different marginal costs.
Collusive oligopolies are more likely when we see:
High entry barriers, low number of firms, and similar marginal costs
What commonly happens with pricing in an oligopoly?
Firms in an oligopoly may engage in a price war.
By fiercely cutting prices (sometimes called ‘predatory pricing’), firms are trying to gain market share.
The idea is that by aggressively cutting prices, you will drive other firms out of the market because they can no longer compete.
New firms will be discouraged to enter because of the low profits being made.
Once firms have been driven out of the market, non-price competition can be used to maintain market share.
What are the advantages of an oligopoly?
Informal collusion is less likely than it may appear, as one firm tends to defect, which brings down the entire cartel.
This could lead to price wars, which are good for consumers due to the lower prices.
Collusive oligopolies can achieve dynamic efficiency through non-price competition and product development.
Competitive oligopolies also have the potential to be very efficient
What are example of oligopolies ?
Big 6 energy companies
Coca-cola and Pepsi
Mobile phone networks
How are the ‘Big Six’ energy companies an oligopoly?
Although this has since reduced, the ‘Big Six’ UK energy providers controlled virtually all of the gas and electricity markets.
They have been accused of price fixing by politicians and made such large profits that there were calls for a special, one-off tax on these.
The CMA has investigated this industry recently and it is under constant scrutiny.
There are high barriers to entry and brand loyalty, mainly due to customers not switching to cheaper suppliers when this is possible
How is Coca-cola and Pepsi an oligopoly/duopoly?
Technically, a market with two dominant sellers is called a duopoly.
However, the interdependence and behaviour of these firms would be the same with three or more sellers and so Coca-Cola and Pepsi could be considered here.
They have such strong brands that barriers to entry are very high and they also have strong price-setting power.
Coca-Cola and Pepsi are also very dependent on each other in terms of their price and promotion levels.
How are mobile phone service providers an oligopoly ?
There are several main mobile phone service providers in the UK, including Vodafone, EE, O2, etc.
There are high barriers to entry due to the need to have a licence to operate and these firms spend heavily on marketing and promotions to gain customers.
BT bought EE for £12.5bn after the CMA approved the deal, deciding that it would not cause there to be a substantial reduction in the level of competition.
What is the Prisoners Dilemma ?
a scenario where the benefits from cooperating are larger than the benefits of pursuing self-interest.
What is game theory ?
The Prisoner’s Dilemma is a type of game theory.
This is a branch of mathematics where one analyses situations in which players must make decisions and then either benefit or lose out from the decisions of other players
What is the scenario for the prisoners dilemma ?
Two criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms.
Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.”
Over in the next room, another police officer is giving exactly the same speech to Prisoner B.
What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.
The prisoners dilemma:
Two criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms.
Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.”
Over in the next room, another police officer is giving exactly the same speech to Prisoner B.
What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.
Why is this a dilemma ?
If the two prisoners had both stayed silent, they would serve a total of four years in jail time between them.
The prisoners would be better off if they cooperate with each other and neither confesses.
If they pursue their own self-interest, they could receive longer jail terms.
What is the oligopoly version of the prisoners dilemma for output ?
If oligopolists cooperate in reducing output, then everyone can maintain high profits.
If an oligopolist is pursuing its own self interest, however, then they would increase its output and then earn even more profits.
Firm A being cheated by Firm B
If A thinks B will cheat and increase their output, then A will also increase their output.
This means that both firms receive £400 in profits.
This is better than the profit of £200, which will happen if A doesn’t change their output levels.
But this is lower than the £1,000 which A would have if B stuck to their agreement.
Firm A cheating Firm B
On the other hand, A could believe that B will stick to their agreement.
If so, they will want to take advantage of this and raise their own output.
This means that they will receive £1,500 in profits.
Their competitor, B, will only have £200 in profits.
Overall, it is in the best interest of Firm A and Firm B to both cooperate.
Ultimately, however, they need to trust each other
Why would oligopolists want to reduce output?
To maintain high profits
How can governments reduce collusion in an oligopoly ?
Increasing punishments
Keeping markets competitive
Whistle blowing
How does increasing punishment reduce collusion in an oligopoly ?
If there is a very significant fine for collusion then firms are less likely to collude.
British Airways was fined £270m in 2007 for colluding on price with another airline, Virgin Atlantic.
How does keeping markets competitive reduce collusion in an oligopoly?
By keeping the number of firms in the market high they make it harder for firms to agree on colluding, reduce the payoff and increasing the chance of a whistleblower.
How does whistle blowing reduce collusion in an oligopoly?
Encouraging firms to come clean about collusion, without them being punished, makes it more likely that collusion will be revealed.
What are the issues of collusion ?
Firms who collude or form cartels make the market less competitive and exploit their customers
What’s the outcome of a collusive oligopoly?
Firms colluding can result in outcomes similar to a monopoly.
Because of this, consumers are likely to have lower consumer surplus and producers will have higher producer surplus.
Firms colluding on price will restrict their output and raise their prices closer to the profit maximising level (marginal cost equals marginal revenue).
This creates a deadweight welfare loss to society and is statically inefficient.
But firms will still compete in non-price competition, particularly through marketing.
What’s the outcome of a non-collusive oligopoly ?
A non-collusive oligopoly will still have a deadweight welfare loss, because output will not be at the statically efficient level of product that would be created under perfect competition.
However, output is likely to be higher and prices are likely to be lower than in a collusive oligopoly.
What is OPEC ?
OPEC is an organisation that coordinates 15 oil-producing countries. They try to manage the supply and therefore the price of oil for the benefit of their members
Is OPEC an oligopoly ?
Despite the fact that there are 15 members, the oil-producing countries could be said to operating as a collusive oligopoly as they regularly meet and coordinate their output to manage the price of oil.
There are clearly high barriers to entry and supernormal profits in the long-run.
The countries are also interdependent.
What are the difficulties for OPEC ?
Having so many members can make it extremely difficult to coordinate and control total output.
The temptation for governments to ‘cheat’ and sell a little more oil to boost revenue is high as it is so lucrative.
This drives the market price of oil down
What does modelling demand as kinked explain ?
Price stability in oligopolies
What does the kinked demand curve (for oligopolies) rely on ?
It relies on the assumption that if one firm raises price, no-one will follow, and if a firm lowers price, then everyone will follow.
There is an equilibrium price.
Any price above this, the demand curve is elastic; any point below, it is inelastic.
So if a firm raises its price, the fall in quantity sold means total revenue will fall.
If a firm lowers its price, the other firms in the oligopoly will follow. This position is stable.
Why is there a ‘kink’ in the demand curve for an oligopoly?
The ‘kink’ is at the current market price which other small number of other firms in the market already set at. Initially the firm also chooses to produce at that price.
Demand above the current market price is elastic and below the current market price is inelastic.
How do firms choices effect the where they are on the kinked demand curve ?
If the firm chooses to raise its price, rivals stick at the original price and steal their customers.
If the firm chooses to lower its price, rivals will follow and cut their own prices in order to maintain their market share.
As a result of the market price falling there is a small increase in quantity demanded but it’s shared among all the firms in the market.
Prices remain stable at the kink point because each firm knows if they increase or decrease their prices they’ll lose profit.
Why would keeping markets competitive NOT reduce the likelihood of collusion?
The reward for collusion rises
In the prisoners dilemma what is the Nash equilibrium ?
A Nash Equilibrium is the point in the Prisoners’ Dilemma problem, where both players are getting the best outcome possible, assuming that what the other player does is already fixed.
Where is the Nash equilibrium point in the prisoners dilemma ?
Confess-confess
Both prisoners remaining silent is not a Nash Equilibrium because if Player B is fixed at remaining silent, Player A would get 1 year less in jail by confessing.
If the other player confesses, moving from confessing to remaining silent adds 3 years to the prisoner’s jailtime.
Prisoners dilemma more detail (with real life context):
The model
This is a two-player game illustrating game theory.
Imagine there are two suspects being interviewed separately by the police accused of jointly committing the same crime.
Importantly the prisoners can’t talk to each other during the interrogation.
Each prisoner has the choice between ‘staying silent’ and ‘confessing’.
With cooperation
The prisoners’ dilemma explains why firms cooperate with each other.
Players without cooperation reach a Nash equilibrium, where no single player can achieve a superior outcome by moving because of uncertainty.
This is, confess confess, where both prisoners get 5 years.
Without cooperation
With cooperation, firms can both agree to switch and achieve a mutually better outcome.
They can agree to remain silent and get 2 years.
By colluding, the firms can make higher returns
Prisoners’ dilemma - defecting
The prisoners’ dilemma also explains first mover advantage.
Having both colluded, if one player defects, their outcome improves further.
This is why some firms may choose to defect when they are in a cartel/oligopoly, like The Organization of the Petroleum Exporting Countries (OPEC).
Who in 2003 did research into the impact that oligopolies had on markets, prices and consumers ?
Posner (2003) - The Social Costs of Cartels (Oligopolies)
What did Ponser find in his research about oligopolies ?
Posner did research into the impact that oligopolies had on markets, prices and consumers.
Posner found that the cartel in the aluminium industry caused a 100% increase in price with a ‘social cost’ worth 75% of the aluminium industry’s total sales.
What factors effect the likelihood of collusion ?
The number of firms in the industry
The interest rates
The frequency of sales
The ease of detecting cheaters
The ease of market entry
The regularity of orders
The cyclicality of the industry
How do lots of firms in an industry make collusion more difficult?
Lots of businesses - having to co-ordinate between lots of businesses makes collusion harder.
How do interest rates make collusion less likely ?
High interest rates - because interest rates are high, future profits are discounted more heavily, so cheating today is more attractive.
How does the ease to detect cheating make collusion less likely?
Easy to detect cheating - things like price comparison sites can make cheating very obvious.
How does ease to enter the market make collusion less likely ?
Easy market to enter - Motta (2004) shows that if it is easy to enter a market, firms are less likely to collude as a new entrant
How does the cyclicality of an industry make collusion less likely ?
Cyclical industry - Rotemberg & Saloner (1986) found that cyclical industries that do well in booms and badly in recessions are less likely to collude. They will all have spare capacity in a recession and will have an incentive to cheat.
Why does having high amount of orders mean business are more likely to collude ?
Motta found that if orders are placed more regularly, then businesses are more likely to collude and less likely to cheat. If orders are regular and small, then the profits made each month are relatively small. If there were 1 large contract every 2 or 3 years, then there would be an incentive to cheat and try to win the contract.
Which TWO authors found that more cyclical industries are less likely to collude?
Saloner
Rotemberg
What’s a pure monopoly?
A pure monopoly is where one firm dominates a market for a good or service
What are the characteristics of a monopoly ?
Monopolies are price-setters. They choose the price at which the product is sold.
Monopolies can get monopoly power legally:
E.g a patent can stop other firms from entering a market.
E.g a convincing advertising campaign that suggests a particular brand of drink is better than others can lead to a higher market share.
E.g an industry may not have many firms competing within it
How is a monopoly modelled ?
The monopoly demand curve is downward sloping.
It will aim to maximise profits and so produce where marginal cost (MC) is equal to marginal revenue (MR).
Here, supernormal profits are made.
These profits are made in the long run also.
The supernormal profits can be reinvested and dynamic efficiency can be achieved in the long run.
What is the static efficiency of a monopoly like ?
The monopoly is not productively efficient because marginal cost is not equal to average cost.
The equilibrium price in the long run is above marginal cost. So it is not allocatively efficient either.
Pm is above Pc.
How can monopoly power arise ?
Limited competition in the market - when there are only a few firms in a market, they will usually have some pricing power.
Differences in products and advertising - firms may gain price-making power if consumers want their products more than others.
Barriers to entry stopping new competitors from joining the market.
How do monopoly’s maximise their profit ?
Where firms are price setters in the market, we assume they will aim to maximise profit by setting the output and quantity where marginal revenue equals marginal cost.
This is profit maximising as if the firm produced any more then the cost of producing each extra unit would be greater than the extra amount earned by selling that unit.
Which type of efficiency could a monopoly be?
Dynamically
What are the advantages of a monopoly ?
A monopoly can benefit from economies of scale.
E.g a firm could bulk buy on raw materials because they have a large market, reducing cost per unit.
Dynamic efficiency can be achieved if a firm wants to reinvest its profits.
Monopolies can create employment and jobs, like businesses in other industries.
The ability to invest lots of profits in R&D and intellectual property can benefit the firm and society with new advances e.g Bell Labs in the USA invested heavily in Telecoms.
What’s are the disadvantages of a monopoly ?
Consumers have fewer products to choose from.
There is no guarantee that a monopoly will reinvest their profits and achieve dynamic efficiency.
By the same logic, firms may not actually improve overall efficiency, even though they have the ability to do so.
What are natural monopolies ?
Some industries have very high fixed costs. These industries may be natural monopolies.
Natural monopolies are characterised by endless economies of scale, so the long run average cost continues to fall as output increases.
In a natural monopoly, having one firm is usually more efficient than having two firms. For example, in the railways, it doesn’t make sense for two firms to lay railway tracks next to each other. This would be inefficient.
What are the characteristics of a natural monopoly ?
High fixed costs
High barriers to entry
Why do firms use price discrimination ?
to capture consumer surplus (the difference between someone’s willingness to pay and the price they pay)
What are the conditions needed for price discrimination?
The groups being discriminated between must have a different price elasticity of demand.
There must be a way of stopping arbitrage opportunities that arise from consumers buying cheap, and selling to those who have been charged a higher price.
The firm discriminating must be a price-setter.
What is first degree pice discrimination ?
First degree price discrimination involves a complete transfer of consumer surplus (the disparity between the price the consumer is willing to pay and the actual product price) to the producer.
This is because each customer is charged the very maximum they are happy and able to pay for a good or service.
Why is first degree price discrimination rarely used ?
This method is rarely used because of asymmetric information, and the difficulty of gathering information on every customer.
What is second degree price discrimination?
Second degree price discrimination involves charging different prices based on the quantity purchased.
The more you purchase, the cheaper the product.
This generates revenue from part of the consumer surplus that has been transferred.
It also rewards customers for making larger orders.
Bulk buying from a wholesaler like Costco may lead to cheaper prices. This is second degree price discrimination.
What is third degree price discrimination ?
This charges different prices to customers based on which segment they are in - different age groups, geographies and industries.
Software companies like Balsamiq charge different prices for non-profits.
This is based on the idea that different segments of a market will have different price elasticity of demands. Profits are maximised when the price is set where marginal cost is equal to marginal revenue for each particular segment.
Firms with more inelastic demand will be charged a higher prices
What’s the impact of third degree price discrimination?
Consumers with more inelastic demand will be charged a higher price. They will receive less consumer surplus than if a firm could not segregate the two groups.
What’s an advantage of price discrimination?
Price discrimination will lead to increased revenue for the firm. Higher profits could be reinvested and improve dynamic efficiency.
Price discrimination often means that those with higher incomes pay more for a good or service than those with lower incomes. This may help cross-subsidise products so that poorer people can afford them.
E.g Google Chromebooks in schools.
To decide whether this is fair and improves equality or not, we need to make a value judgement
