3 - Market Structures

Question 1

Allocative efficiency

Answer 1

• Where P = MC
• Resources are distributed according to consumer preference
• Social welfare is maximised

Question 2

Productive efficiency

Answer 2

• Where MC = AC, this is at the bottom of the AC curve
• Products are being produced at the lowest average cost
• It means that a firm is using all its resources in the most efficient way possible, producing the maximum output with the minimum input

Question 3

Dynamic efficiency

Answer 3

• Achieved when resources are allocated efficiency over time
• Occurs when competition encourages innovation and thus, firms are willing to use supernormal profits to reinvest into the business to bring new products and new production techniques

Question 4

X-inefficiency

Answer 4

• Occurs when a firm fails to minimise its average cost at a given level of output due to a lack of competition motivation
• Production occurs above the average cost curve
• Typically occurs in a monopoly due to lack of competition however, firms aim to maximise profits

Question 5

What are the characteristics of perfect competition?

Answer 5

-Perfect Knowledge
-No barriers to entry or exit
-Homogenous goods
-Many buyers and sellers

Question 6

Assumptions of firms in markets of perfect competition

Answer 6

-Firms are price takers
-Firms are assumed to short-run profit maximise
-In the short-run, it is possible for firms to make a normal profit, supernormal profit or a loss
-In the long-run, firms may only make normal profit
-No economies of scale because there are many firms producing relatively small amounts

Question 7

What efficiencies are there in a perfect competitive market?

Answer 7

Remember: firms aim to profit maximise (MC=MR) and firms are price takers (MR=AR)
-Allocative efficiency
-Productive efficiency
-No dynamic efficiency because of the existence of perfect knowledge, so the invention of one firm will be adopted by another, so investment will give firms no competitive benefit.

Question 8

Characteristics of monopolistic competition

Answer 8

-Many buyers and sellers
-Product differentiation
-No barriers to entry or exit

Question 9

Assumptions of monopolistic competition

Answer 9

-Firms aim to maximise profit
-In the short-run, firms can make normal profit, supernormal profit and a loss
-In the long-run, firms can only make normal profit because there are no barriers to entry or exit

Question 10

Limitations of the monopolistic competition model

Answer 10

Information may be imperfect so firms will not enter the market as predicted because they are unaware of the existence of supernormal profits

Question 11

Efficiencies in monopolistic competition

Answer 11

Remember: MR does not equal AR, firm are only able to make normal profit in long run so AR=AC and profit maximise so MR=MC

-No allocative or productive efficiency
-They are likely to be dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run. However, since the firms are small, they may struggle to have the retained profits necessary to invest

Question 12

Characteristics of an oligopoly

Answer 12

-Product differentiation
-Firms are interdependent (the actions of one firm will impact on the other firms in the industry thus, firms make decisions based on the actions and/or reactions of other firms)
-High barriers to entry and exit
-High-concentration ratio (supply in the industry is dominated by a relatively small amount of firms)
-Non-price competition (price cutting will lead to price wars which results in loss of revenue)
-Profit maximisation is not sole objective (market share plays a crucial role)

Question 13

N-firm concentration ratio

Answer 13

Total amount of market share the ‘n’ biggest firms in the industry have as a proportion of the whole market

Question 14

Collusion definition

Answer 14

• Collusion is where firms make a collective agreement to reduce competition
• This is done by firms through cooperate to fix prices and/or restrict output

Question 15

What is the difference between overt and tacit collusion?

Answer 15

Overt = formal agreement
Tacit = No formal agreement, collusion is implied (price leadership or no price wars)

Question 16

Why do firms collude?

Answer 16

• Maximise industry profits (avoids competitive pricing and advertising costs)
• Market stability (reduces uncertainty in the market, avoids price wars)
• Protect market share (increasing barriers to entry - for example predatory pricing)

Question 17

Price leadership

Answer 17

Price leadership occurs where firms follow the pricing decisions of the dominant firm in the market

Question 18

What are factors promotion collusive oligopoly?

Answer 18

• Small amount of firms (easier to organise collusion)
• Similar costs (easier to agree on a fixed price)
• High barriers to entry (supernormal profit would attraction new firms otherwise)
• Consumer loyalty (not beneficial to cut prices so cheating is less likely)

Question 19

What are factors encouraging competitive oligopoly/discouraging collusion?

Answer 19

-Large number of firms
-Low barriers to entry and exit
-Saturated market
-Homogenous goods
-One firm has significant cost advantage

Question 20

Why is there a temptation to break collusion?

Answer 20

• To maximise a firm’s sales by lowering prices and catching rivals unaware
• To gain immunity from prosecution by acting as a whistle-blower and informing the competitive authorities

Question 21

How could you explain why oligopoly markets have price rigidity and consequently, non-price competition?

Answer 21

Through kinked demand curve and/or game theory - prisoners dilemma model

Question 22

What is a dominant strategy and in which model can it be shown?

Answer 22

It’s a course of action that gives the best outcome regardless of what the other firm does.

For example, in a duopoly where firms can choose between high or low prices:
If Firm A sets a high price, Firm B’s best response is to set a low price to capture more market share.
If Firm A sets a low price, Firm B’s best response is still to set a low price to remain competitive.

This can be shown through the prisoner’s dilemma

Question 23

What is nash equilibrium and what model helps you demonstrate it?

Answer 23

• Nash equilibrium is where neither player is able to improve their position
• They both have a dominant strategy, and have optimised their outcome based on the other players expected decision
• They have no incentive to change behaviour, unless someone else changes theirs
• It is best represented in the prisoners dilemma model

Question 24

What does the prisoners dilemma model show us?

Answer 24

• That firms in oligopoly are interdependent and thus make decisions based on the other’s actions
• Rational self-interest can lead to collectively suboptimal outcomes
• Price rigidity
• Firms have temptations to collude
• Incentive to cheat on collusive agreement

Question 25

What are Price Wars?

Answer 25

Price wars are where competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share

Question 26

Why do price wars occur?

Answer 26

-Low levels of non-price competition (goods have weak brands and consumers are price conscious) -Firms find it difficult to collude

Question 27

A price war can result in firms making a frequent loss, what conditions have to be met for firms to be able to make a loss?

Answer 27

AVC < AR - This can only happen in the short-run (firms will leave the market if this continues; reducing supply and increasing prices)

Question 28

Predatory pricing

Answer 28

- This is the practice of lowering prices when a new competitor joins the industry in order to drive them out - Prices are often lowered to a point below the cost of production. - Once they have left the market, prices are raised again - This pricing strategy is usually illegal.

Question 29

Limit pricing

Answer 29

- Occurs when firms set a limit on how high the price will go in the industry - A lower price reduces profit and disincentivize other firms from joining the industry - The greater the barriers to entry the higher the limit price is likely to be as firms are already disincentivized

Question 30

What are some types of non-price competition?

Answer 30

- Loyalty cards - Branding - Product warranties - Corporate Sponsorship (Red bull) - Advertising

Question 31

What are the efficiencies in an oligopoly?

Answer 31

- No productive or allocative efficiency (so statically inefficient) - Able to explore economies of scale - Dynamically efficient as are able to make supernormal profit and have competition which encourages investment in innovation however, they may decide to not invest or split the profits with shareholders

Question 32

Pure monopoly definition

Answer 32

Where one firm is the sole seller of a product in the market, in the real world this rarely exists.

Question 33

When is a firm legally considered to have monopoly power?

Answer 33

When they have more than 25% of the market share

Question 34

What are the characteristics of a monopoly?

Answer 34

- One firm in the industry - Aim to maximise short-run profits - High barriers to entry - Will be making supernormal profit as there is no freedom to enter and exit the market

Question 35

Third degree price discrimination

Answer 35

When monopolists charge different prices to different people for the same good or service. - It is not illegal

Question 36

When can third-degree price discrimination occur?

Answer 36

- The firm must be able to separate the market into groups of buyers - The costumers must have different price elasticities of demand - They must be able to control supply and prevent buyers from the expensive market from buying in the cheap market

Question 37

Third degree price discrimination benefits and costs

Answer 37

- Firms are able to increase profits, this can go into research and development; improving dynamic efficiency - Those in elastic markets are able to pay a lower price than they otherwise would, they benefit from cross subsidisation, these consumers may have not been able to access the good if it weren’t’ for price discrimination so this may increase equality However, - Some consumers have to pay higher prices, thus reducing their consumer surplus and increasing producing surplus

Question 38

Economic cost

Answer 38

Cost of using economic resources + opportunity cost

Question 39

What are the types of economies of scale

Answer 39

THINK: Really fun mums try making pies - Risk-bearing economies - Financial economies - Managerial economies - Technical economies - Marketing economies - Purchasing economies

Question 40

What does D.O.S mean for businesses?

Answer 40

They have passed their optimal size, may lead to demerger

Question 41

What is a cartel

Answer 41

Businesses who recognise interdependence and act together to profit maximise

Question 42

Types of price competition

Answer 42

- Price wars - Predatory pricing - Limit pricing