Perfect Competition, Imperfectly Competitive Markets and Monopoly

Question 1

The Spectrum of Competition

Answer 1

1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

Question 2

How to distinguish between different market structure

Answer 2

1. Number of farms in the market (competitiveness)
2. The degree of product differentiation. (The more differentiated the products,
   the less competitive the market)
3. Ease of entry into the market
4. The degree to which perfect knowledge exists in the market
5. The degree to which the actions of firms are independent of each other or interdependent

Question 3

Profit Maximisation

Answer 3

MR=MC

Question 4

Reasons for the consequences of a divorce of ownership from control

Answer 4

1. The principle-agent problem
2. When an owner of a firm sells shares, they lose some of the control they had over
   the firm
3. When a manager sells their shares, shareholders gain more control over the
   decisions of the firm. This could give rise to ‘shareholder activism’

Question 5

Other possible objectives of a firm

Answer 5

1. Survival (e.g. 2008 financial crisis)
2. Growth
3. Increasing their market shares
4. Quality
5. Maximise sale revenue (MR=0)

Question 6

The Satisficing Principle

Answer 6

a decision-making process in which an individual or organization settles for a satisfactory solution rather than striving for the optimal solution. e.g. enough profit to keep shareholders happy

Question 7

Perfect competition profit in short/ long run

Answer 7

In the short run, firms can make supernormal profits. In the long run where profits are competed away, only normal profits are made.

Question 8

Implications for firms and the industry of perfect competition

Answer 8

Large numbers of producers
Identical products
Freedom of entry and exit
Perfect knowledge
Price takers

Question 9

Firms operating in perfect competition are price…

Answer 9

takers

Question 10

Efficiency’s Golden Child (Perfect Competition)

Answer 10

Productive Efficiency: Firms operate at the minimum efficient scale, minimizing production costs and ensuring output at lowest per-unit cost.
Allocative Efficiency: The market price equals the marginal cost of production, meaning consumers pay exactly what it costs to produce the last unit, reflecting true social value.
No Deadweight Loss: Efficient allocation minimizes societal waste and maximizes consumer surplus (the difference between what consumers are willing to pay and what they actually pay).

Question 11

Characteristics of monopolistically competitive markets

Answer 11

Many firms, but not as many as in perfect competition.
Products are similar, but not identical - they have some differentiation, like branding or slight differences in features.
Firms have some control over price, but not as much as in a pure monopoly.
Entry and exit are somewhat easier than in monopolies, but not as easy as in perfect competition.

Question 12

Monopolistically competitive markets will be subject to…

Answer 12

Non-price competition

Question 13

Main characteristics of an oligopoly

Answer 13

1. Few Dominant Firms
2. Interdependent
3. Significant barriers to entry
4. Non-price competition

Question 14

Concentration ratio

Answer 14

The concentration ratio of a market is the combined market share of the top few
firms in a market

Question 15

Collusive oligopoly (cartel)

Answer 15

where firms enter into agreements with each other (collude) in order to reduce the uncertainty that comes from interdependence. The market ends up acting like a pure monopoly (restricting output, raising prices/profits and restricting choice) but without the potential benefits of monopoly such as greater economies of scale or the incentive to be more dynamically efficient.

Question 16

Non-collusive oligopoly

Answer 16

where firms do not enter into agreements with each other (do not collude)

Question 17

Difference between cooperation and collusion

Answer 17

Cooperation is allowed in the market, whilst collusion is not. Collusion is usually with
poor intentions, whilst cooperation will be beneficial

Question 18

A Cartel

Answer 18

is a group of two or more firms which have agreed to control prices, limit
output, or prevent the entrance of new firms into the market. A famous example of
a cartel is OPEC, which fixed their output of oil. This was possible since they
controlled over 70% of the supply of oil in the world.

Question 19

Price Leadership

Answer 19

when one firm changes their prices, and other firms follow.
This firm is usually the dominant firm in the market. Other firms are often forced
into changing their prices too, otherwise they risk losing their market share.

Question 20

Price Wars

Answer 20

When firms constantly cutting their prices below that of its competitors

Question 21

Barrier to Entry

Answer 21

Firms might try to drive competitors out of the industry in order to
increase their own market share. Barriers to entry are designed to prevent new firms
entering the market profitably. This increases producer surplus.

Question 22

Game theory

Answer 22

(used to illustrate interdependent decision making in oligopolistic markets and the uncertainty that arises from it, the incentive to collude and the incentive to cheat on collusive agreements)

Question 23

Prisoners Dilemma

Answer 23

a model based around two
prisoners, who have the choice to either confess or deny a crime. The consequences
of the choice depend on what the other prisoner chooses.

The dominant strategy is the option which is best, regardless of what the other
person chooses. This is for both prisoners to confess, since this gives the minimum
number of years that they have to spend in prison. It is the most likely outcome.
This is still higher than if both prisoners deny the crime, however. If collusion is
allowed in this dilemma, then both prisoners would deny. This is the Nash
equilibrium.

Question 24

Nash equilibrium

Answer 24

a concept in game theory which describes the optimal strategy
for all players, whilst taking into account what opponents have chosen. They cannot
improve their position given the choice of the other.

Question 25

Advantages of an Oligopoly

Answer 25

1. Oligopolies can earn significant
   supernormal profits, so they might invest
   more in research and development. This
   can yield positive externalities, and make
   the monopoly more dynamically efficient
   in the long run. There could be more
   invention and innovation as a result.
   Moreover, firms are more likely to
   innovate if they can protect their ideas.
   This is more likely to happen in a market
   where there are high barriers to entry.
2. Higher profits could be a source of
   government revenue.
3. Industry standards could improve. This is
   especially true in the pharmaceutical
   industry and for car safety technology.
   This is because firms can collaborate on
   technology and improve it. It saves on
   duplicate research and development.
4. Since oligopolies are large, they can
   exploit economies of scale, so they have
   lower average costs of production.

Question 26

Disadvantages of Oligopoly

Answer 26

1. The basic model of oligopoly suggests
   that higher prices and profits and
   inefficiency may result in a misallocation
   of resources compared to the outcome
   in a competitive market
2. If firms collude, there is a loss of
   consumer welfare, since prices are raised
   and output is reduced.
3. Collusion could reinforce the monopoly
   power of existing firms and makes it
   hard for new firms to enter. The absence
   of competition means efficiency falls.
   This increases the average cost of
   production.

Question 27

Monopoly

Answer 27

when one firm dominates the market with more than 25% market share

Question 28

Monopoly power is influenced by factors such as…

Answer 28

1. High barriers to entry e.g. economies of scale, limit pricing, owning a resource, sunk/ set up costs, brand loyalty
2. Number of competitors
3. Advertising
4. The degree of product differentiation

Question 29

Advantages of a monopoly

Answer 29

1. Monopolies can earn significant
   supernormal profits, so they might invest
   more in research and development. This
   can yield positive externalities, and make
   the monopoly more dynamically efficient
   in the long run. There could be more
   invention and innovation as a result.
   Moreover, firms are more likely to
   innovate if they can protect their ideas.
   This is more likely to happen in a market
   where there are high barriers to entry, such as in a monopoly
2. If there is a natural monopoly, it might be
   more efficient for only one firm to
   provide the good or service, since having
   duplicates of the same infrastructure
   might be wasteful. For example, it might
   be considered inefficient and wasteful to
   have two lots of water suppliers.
3. Monopolies could generate export
   revenue. For example, Microsoft
   generates a lot of export revenue for
   America.
4. Since monopolies are large, they can
   exploit economies of scale, so they have
   lower average costs of production.
5. High profits could be a source of
   government revenue through taxation.

Question 30

Disadvantages of monopoly

Answer 30

1. The basic model of monopoly suggests
   that higher prices and profits and
   inefficiency may result in a misallocation
   of resources compared to the outcome
   in a competitive market.
2. Monopolies could exploit the consumer
   by charging them higher prices. This
   means the good is under-consumed, so
   consumer needs and wants are not fully
   met. This loss of allocative efficiency is a
   form of market failure.
3. Monopolies have no incentive to
   become more efficient, because they
   have few or no competitors, so
   production costs are high.
4. There is a loss of consumer surplus and a
   gain of producer surplus. If a monopolist
   raises the market price above the
   competitive equilibrium level, output will
   fall from Q1 to Q2. This leads to gains in
   producer surplus.
5. Consumers do not get as much choice in
   a monopoly as they do in a competitive
   market.

Question 31

Price discrimination

Answer 31

occurs in a monopoly, when the monopolist decides to charge different groups of consumers different prices, for the same good or service. This is not for cost reasons

Question 32

Conditions necessary for price discrimination

Answer 32

1. The ability to identify different groups in the market e.g. age, time and geography.
2. The ability to keep the different groups separate AT LOW COST
3. Differences in price elasticity of demand between markets

Question 33

Examples of Price Discrimination

Answer 33

1. First Degree or Perfect Price Discrimination- when each consumer is charged a different price. For example, a lawyer might charge a high income family
   more than a low income family.
2. Second degree price discrimination- is when prices are different according to
   the volume purchased e.g. airline last seats.
3. Third degree price discrimination- is when different groups of consumers are
   charged a different price for the same good or service e.g. children v adults

Question 34

Consumer welfare impacts from price discrimination

Answer 34

Costs:
-Consumer surplus is reduced for those paying the higher prices, since P>MC loss of allocative efficiency
-It strengthens the monopoly power of firms, which could result in higher prices in the long run for consumers.

Benefits:
-Consumers could benefit from a net welfare gain as a result of cross subsidisation, if they receive a lower price.
-Good examples to use here might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) which then have implications for the overall level of social welfare and the equity with which scarce resources are allocated. Educational rates for some products/services would be another good example of this.

Question 35

The impact of producer welfare impacts from price discrimination

Answer 35

Costs:
-Price discrimination might also be used as a predatory pricing tactic - setting prices below cost to certain customers - to harm competition at the supplier’s level and thereby increase a firm’s market power. This type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK and European Union competition authorities.

Benefits:
-A discriminating monopoly is extracting consumer surplus and turning it into extra supernormal profit.
- Make better use of spare capacity
- If more profits are made in one market, a different market which makes losses could be cross subsidised, especially if it yields social benefits. This will limit or prevent job
losses, which might result from the closure of the loss-making market.

Question 36

Short-run and long-run benefits which are likely to result from
competition

Answer 36

• In the long run, firms are likely to be more productively and allocatively efficient.
  This is because they provide the goods and services that consumers want, and
  competitive pressure forces them to lower their costs of production.
• In the short run, firms might make supernormal profits, which can be reinvested back into the firm. This can increase dynamic efficiency and lower LRAC.
• Consumers get a wide variety of choice due to the number of firms in the market.
  Goods and services are likely to be of a higher quality, since firms are trying to gain
  consumer loyalty

Question 37

Firms do not must compete on price. Firms might also aim:

Answer 37

• Improve products/ service(quality)
• Reduce costs

Question 38

Creative destruction

Answer 38

Schumpeter, an economist, proposed the idea of ‘creative destruction’. This is the
idea that new entrepreneurs are innovative, which challenges existing firms in the market. The more productive firms then grow, whilst the least productive are forced to leave the market. This results in an expansion of the economy’s productive
potential.

Question 39

Contestable markets

Answer 39

there are no entry or exit barriers, no sunk costs and where both incumbent firms and new entrants have access to the same level of technology

Question 40

Implications of contestable markets

Answer 40

• More likely to become allocative efficient
• The threat of new entrants affects firms just as much as existing competitors
• There could be supernormal profits in the short run and only normal profits in the
  long run

Question 41

Sunk Costs

Answer 41

They are costs which cannot be recovered one they have been spent e.g. advertising

Question 42

Hit-and-run competition

Answer 42

when firms enter and exit the market quickly, selling their product for a short period of time and then leaving.

Question 43

Static efficiency

Answer 43

the level of efficiency at one point in time. Productive and allocative efficiencies are examples of static efficiency.

Question 44

Dynamic efficiency

Answer 44

is concerned with new technology and increases in productivity, which causes efficiency to increase over a period of time

Question 45

Conditions required for productive efficiency

Answer 45

Productive efficiency occurs when firms minimise their average total costs.

This is when firms produce at the lowest point on the average cost curve. Since the
MC curve cuts the AC curve at the lowest point, MC = AC is a point of productive
efficiency. All points on the PPF curve are productively efficient.

Question 46

Conditions required for allocative efficiency

Answer 46

Allocative efficiency occurs when resources are distributed to the goods and services
that consumers want. This maximises utility. It exists at P = MC, which means that
consumers pay for the value of the marginal utility they derive from consuming the good or service. Free markets are considered to be allocatively efficient.

Question 47

Dynamic efficiency is influenced by

Answer 47

research and development,
investment in human and non-human capital and technological change

Question 48

Consumer surplus

Answer 48

This is the difference between the price the consumer is willing and able to pay and
the price they actually pay

Question 49

Producer surplus

Answer 49

This is the difference between the price the producer is willing to charge and the
price they actually charge.