3.4 Market Structures

Question 1

What is economic efficiency ?

Answer 1

• making optimal use of scarce resources to help satisfy changing wants & needs ➡️ how well a market system allocates scarce resources to satisfy consumers

Question 2

What is allocative efficiency ?

Answer 2

• occurs when the value that consumers place on a good/service (reflected in the price they are willing and able to pay) = the cost of the factor resources used up in production
• AR = MC ➡️ ie. demand = supply
• social efficiency is the same (MSB = MSC)

Question 3

What is productive efficiency ?

Answer 3

• occurs when firms max production while minimising costs ➡️ exploits all economies of scale
• min point on AC curve (AC = MC) in SR
• at minimum efficient scale in LR

Question 4

What is dynamic efficiency ?

Answer 4

• when businesses supplying a market successfully meets changing needs & wants over time ➡️ linked to innovation/invention
• occurs when supernormal profits are reinvested ➡️ lower unit costs (AC curve shift downwards)

Question 5

What is innovation ?

Answer 5

• putting new ideas into action ➡️ ‘the commercially successful exploitation of ideas’
• product innovation: small scale & subtle changes to the characteristics and performance of a good/service
• process innovation: changes to the way in which production takes place or is organised + changes in business models & pricing strategies

Question 6

What is X-inefficiency ?

Answer 6

• occurs when firms are being wasteful for lower costs ➡️ any point on AC curve
• when a lack of real competition may give a monopolist a weak incentive to invest in new ideas or consider consumer welfare ➡️ AC higher

Question 7

What is deadweight loss of welfare ?

Answer 7

• the loss in producer & consumer surplus due to an inefficient level of production maybe resulting from one or more market failures or govt failure

Question 8

What is pareto optimality ?

Answer 8

• where it is not possible for households or firms to bargain or trade in such a way that everyone is at least as well off as the were before and at least one person is better off
• exists if there is both allocative efficiency & productive efficiency

Question 9

Allocative efficient ?

Answer 9

✅ perfect competition
❌ monopolistic
❌ oligopolistic
❌ monopoly

Question 10

Productive efficient ?

Answer 10

✅ perfect competition
❌ monopolistic ➡️ profit max instead
❌ oligopolistic ➡️ profit max instead
❌ monopoly ➡️ profit max instead

Question 11

Dynamic efficient ?

Answer 11

✅❌ perfect competition ➡️ LR no but SR possibly
✅❌ monopolistic ➡️ LR no but SR possibly
✅ oligopolistic - make profit but may not reinvest
✅ monopoly - make profit but may not reinvest

Question 12

X-inefficient ?

Answer 12

❌ perfect competition - probably x-efficient
✅ ❌ monopolistic
✅ oligopolistic (less than a monopoly)
✅ monopoly

Question 13

What is perfect competition ?

Answer 13

• market structure whose assumptions are strong, therefore unlikely to exist in the
  vast majority of real-world markets
• however take some insights from studying a world of perfect competition + comparing & contrasting w/imperfectly competitive markets & industries
• eg. small bakeries in a large city, small scale wheat rowers, sporting bets, fruit seller in a big street market

Question 14

Characteristics of perfect competition ?

Answer 14

• many sellers + buyers
• identical costs
• identical/homogenous products
• no entry/exit barriers
• perfect knowledge of the market for all participants (same access to info)
• firms are price takers ➡️ as there are many firms producing identical products therefore consumers can easily switch from one firm to another
• normal profits for all firms in the LR (but SR losses or supernormal profits are possible)
• all firms have access to same quality factors of production
• profit maximisation is assumed as key objective of firms + consumers are assumed to be utility maximisers when making their purchasing decisions

Question 15

Profit maximisation in LR (perfect competition) ?

Answer 15

• produce at the quantity where MR = MC
• LR profit diminished as firms enter the market due to having perfect knowledge & firms making supernormal profits in the SR (profit motive)
• causes an outward shift in supply, forcing down the ruling market price until price = LRAC
• at this point all firms are making normal profits where price (AR) = AC
• other things remaining the same, there is no further incentive for movement of firms in & out of the industry and a LR equilibrium is established where price = AC at output where MR=MC

Question 16

When may a firm consider shutting down production (PC) ?

Answer 16

• in the SR, a business will continue to supply products as long as their revenues at least cover variable costs ie. revenue = AR x Q
• VC are costs that vary directly w/output eg. raw
  materials, component parts & employees paid an hourly wage
• providing that price per unit (AR) > average variable cost (AVC), then a contribution is being made to cover some fixed (overhead) cost
• as a result the firm would be better off continuing production if we assume that FC are lost if a shutdown decision is made
• but, if there is a fall in demand & price drops below AVC, then a firm might decide to shutdown production to minimise their losses
• this is because not enough revenue is being generated & total losses suffered would be
  higher if production continued

Question 17

LR equilibrium in PC ?

Answer 17

• in LR equilibrium, all firms are making normal profits ➡️ Price (AR=AC) ie. breakeven
• firms making sub-normal profits are likely to leave the industry ➡️ causes an inward shift of supply which leads to a rise in the market equilibrium price. In the LR the net exit of firms will allow the remain firms to earn normal profits where price = AC

Question 18

Economic efficiency in PC ?

Answer 18

• ✅ allocative efficiency: both in SR & LR, P = MC
• ✅ productive efficiency: attained in LR, output is at lowest point of AC
• ❌ dynamic efficiency: LR no as lack of supernormal profits but SR possibly + little space for innovation
• ❌ x-inefficient: producing at lowest point of ACC therefore x-efficient

Question 19

Why are competitive markets good for economic efficiency ?

Answer 19

1. lower prices: (due to many competing firms), XED will be high ➡️ consumers prepared to switch their demand to the most competitively priced products
2. low barriers to entry: entry of new firms provides competition + ensures prices are kept low
3. lower total profits & profit margins than in monopoly
4. greater entrepreneurial activity: for competition to be improved & sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate & invent to drive markets
5. competition ensures that firms move towards productive efficiency & avoid x-inefficiency
6. threat of competition should lead to a faster rate of technological diffusion, as firms must be responsive to changing needs of consumers ie. dynamic efficiency

Question 20

Evaluating assumptions of PC model

Answer 20

• most firms have so amount of price setting power - they are price makers not price takers!
• dominance in real world markets of differentiated/branded products
• highly complex products, there always info gaps facing consumers
• impossible to avoid search costs even with the spread of digital/web technology
• patents, control of intellectual property, control of key inputs are all ignored by the PC model
• rare for entry/exit in an industry to be costless
• PC model assumes that there are no externalities (positive/negative) in reality,
  there are often 3rd party effects of every market

Question 21

Pros & cons of PC market structures ?

Answer 21

• points made in relation to efficiency & unrealistic underlying assumptions (diff flash cards)
• ✅ consumers are not exploited by firms, in terms of high prices
• ✅ equality – products are the same regardless of where they are bought (all consumers are able to buy the same product)
• ✅ no ‘wasted’ costs in terms of advertising etc
• ❌ consumers face a lack of choice & cannot necessarily find a product that perfectly meets their needs
• ❌ firms are unlikely to be able to grow large enough to benefit from economies of scale

Question 22

What is monopolistic competition ?

Answer 22

• a form of imperfect competition + can be found in many real-world markets eg. sandwich bars, coffee stores, pizza delivery businesses, hairdressers
• similar to PC but regarded as more realistic as products are differentiated (businesses have some control over their products + implies that firms have some price setting power ie. AR curve slops downwards)

Question 23

Characteristics of monopolistic competition ?

Answer 23

• imperfect competition
• large no. of buyers & sellers ➡️ industry concentration ratio is low
• perfect info
• low barriers to entry/exit - allows firms to respond to profit signals
• selling similar/differentiated products
• firms have a little price making power over their own brand
• firms aim to maximise profit + consumers aim to maximise utility
• economic profit/loss can be achieved in SR
• normal profits achieved in LR
• productively & allocatively inefficient

Question 24

Profit maximisation in LR (MC)

Answer 24

• no barriers to entry/exit therefore new firms are attracted by the SR economic profit and enter the market
• this reduces demand for the original firm
• demand falls, price falls & the curve becomes slightly more elastic
• only normal profits can be made in LR equilibrium ie. AR = AC

Question 25

Economic efficiency in MC ?

Answer 25

• ❌ allocatively efficient: prices above MC
• ❌ productively efficient: saturation of the market meaning businesses unable to exploit fully internal economies of scale causing LR average costs to be higher
• ✅❌ dynamic: LR no but SR possibly + associated w/extensive consumer choice & innovation but lower profit margins
• ✅ ❌ x-inefficiency
• heavy spending on marketing & advertising- wasteful & inefficient use of scarce resources ?
• social costs of packaging & negative externalities from packaging

Question 26

What is an oligopoly ?

Answer 26

• an imperfectly competitive industry where there is a high level of market concentration
• best defined by the actual conduct (or day-to-day behaviour) of firms within a market
• rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of market sales ie. the C5 concentration ratio is above 60%

Question 27

Characteristics of an oligopoly ?

Answer 27

• market dominated by a few large firms (each w/significant market share)
• high entry/exit barriers
• high concentration ratio
• interdependence of firms (will be affected by how other firms set price & output) affect strategic decisions
• differentiated & branded products (similar not identical)
• dominant firms can enjoy economic profits - prices tend to be quite stable/often avoid price competition
• use non-price competition
• changes in ATC don’t necessarily change output

Question 28

What is meant by strategic interdependence ?

Answer 28

• oligopolies are interdependent therefore strategy becomes very important ➡️ must try to anticipate their rivals responses to any changes in their price/non price strategies
• one firm’s output & price decisions are influenced by the likely behaviour of competitors/rivals
• because there are few sellers, each firm is likely to be aware of the actions of the others
• decisions of one firm influence, & are influenced by the decisions of other firms
• this causes oligopolistic industries to be at risk of tacit or explicit collusion which can lead to allegations of anti-competitive behaviour
• in oligopoly there is always a high level of uncertainty

Question 29

What are the key decisions that oligopolies need to make ?

Answer 29

• whether to compete w/rivals or collude
• whether to use price competition or not
• whether to leave prices alone & use non-price competion

Question 30

What is meant by concentration ratio ?

Answer 30

• measures the combined market share of the top ‘n’ firms in the industry ➡️ shares can be by sales, employment or other indicators
• the value of ‘n’ is often 5 but may be 3 or any other small no.
• if top ‘n’ firms gain a high market share = industry is highly concentrated
• if the 5-firm concentration ratio is greater than 60% , then there is an oligopoly

Question 31

What are the 1st and 2nd-mover advantages ?

Answer 31

• the advantages of going first or going second
• sometimes it pays to go first because a firm can generate head-start profits
• 2nd mover advantage occurs when it pays to wait & see what new strategies are launched by rivals and then try to improve on them or find ways to undermine them

Question 32

Non-collusive behaviour in an oligopoly ?

Answer 32

• means that firms do not work together and instead compete w/each other - either in terms of price competition or non-price competition
• all behaviour by businesses in an oligopoly is strategic + will depend on the key objectives of businesses which can vary eg. maintaining a satisfactory rate of profitability, protecting market share, growing their user base, reacting to the decisions of rival firms

Question 33

Non-price competition in an oligopoly ?

Answer 33

• 🔔 key aspect of oligopoly especially when prices are sticky/rigid between competing suppliers
• better quality of customer service eg. good after sales service
• innovation
• advertising & branding
• environmental impact - ethical ?
• longer opening hours eg. 24 hr online customer support
• discounts on product upgrades when they become available in the market
• developing brand loyalty
• exclusivity/loyalty schemes
• variation in design, style, service, quality of product
• contractual relationships w/suppliers eg. Apple signed exclusive distribution agreements w/T-mobiles of Germany, O2 in the UK for the iPhone - gives apple 10% of sales from phone calls & data transfers

Question 34

Why is branding important for oligopolies ?

Answer 34

• significant feature of non-collusive competition, especially in oligopoly where building & maintaining market share is often a dominant business objective

Question 35

Price competition in an oligopoly ?

Answer 35

• prices tend to be quite stable BUT may chose to compete on price, three strategies:
  1. price wars: firms repeatedly cut their prices over time ➡️ may lead to SR increases in sales & revenue but not in LR commercial interests of a business
  2. predatory pricing: occurs when a firm deliberately tries to push prices low enough to force rivals out of the market ➡️ often started by the biggest firm as they are the most dominant (know they will win or less risk if they don’t as have the most cash reserves) ➡️ bigger market share = move towards monopoly
  3. limit pricing: the incumbent firm sets a low price and a high output so that entrants cannot make a profit at that price ➡️ best achieved by selling at a price just below ATC of potential entrants ➡️ this signal to potential entrants that profits are impossible to make ➡️ reduces new entrants + less chance of a firm joining & becoming dominant

Question 36

Issue with oligopolies colluding ?

Answer 36

• higher prices - to ensure supernormal profits but at the expense of the consumer
• lower output
• allocative & productive inefficiency

Question 37

Why may oligopolies not all be bad ?

Answer 37

collusive oligopolies:
- unlikely to last long/temporary ➡️ sooner or later someone will cheat and try ti get first move advantage
- formal collusion is quite unlikely as it’s illegal
- if firms aren’t competing on price then they are likely to be competing strongly in non-price ways ➡️ should lead to improvements in products & quality ie. dynamic efficiency
- firms are unlikely to increase prices too high as this would encourage new entrants to the market

competitive oligopolies:
- can achieve high levels of efficiency
- can still offer high quality, competitive prices etc

Question 38

Key aims of business collusion in an oligopoly ?

Answer 38

1. businesses in a cartel recognise their interdependence + act together ➡️ aim is to maximise joint profits
2. collusion lowers the costs of competition eg. wasteful marketing wars which can run into millions of £
3. collusion reduces uncertainty and higher profits increases producer surplus/shareholder value ➡️ leading to higher share prices

Question 39

What are the legal forms of business collusion/cooperation ?

Answer 39

1. practices are not prohibited if the respective agreements “contribute to improving the production or distribution of goods or to promoting technical progress in a market.”
2. development of improved industry standards of production and safety which benefit the consumer eg. joint industry standards in Europe for mobile phone chargers
3. information sharing designed to give better information to consumers
4. research joint ventures and know-how agreements which seek to promote innovative & inventive behaviour in a market ➡️ EU has introduced R&D Block Exemption Regulation for this

Question 40

What is formal collusion ?

Answer 40

• an agreement between the firms to collude, known as a cartel (usually illegal)
• they often have a desire to achieve joint profit maximisation within a market or prevent price
  & revenue instability in an industry
• price fixing represents an attempt by suppliers to control supply & fix price at a level close to the level we would expect from a monopoly
• to collude on price, producers need some control over market supply, & have strong pricing-making power

Question 41

Conditions when price-fixing cartels are likely to happen in an oligopoly ?

Answer 41

1. industry regulators are ineffective ➡️ regulatory failure
2. penalties for collusion are low relative to gain in profits - fines therefore do not act as a proper deterrent
3. few firms in the market & price inelastic demand (PED<1) – higher prices then lead to increased revenues
4. participating firms have a high % of total sales – allows them to control market supply
5. firms can communicate well & trust each other – this is helped by having similar strategic objectives
6. products are standardised & output within the cartel is easily measurable so that supply can be controlled
7. brands are strong so that consumers will not switch demand when collusion raises prices
8. there are other strong barriers that prevent consumers from switching to other products/ alternatives

Question 42

Why do many price-fixing cartels eventually break down ?

Answer 42

1. enforcement problems:
   - the cartel aims to restrict production to maximise total profits
   - but each individual seller finds it profitable to expand their production
   - other firms who are not members of the cartel may take a free ride by selling under the cartel price
2. falling market demand:
   - eg. recession ➡️ creates excess capacity in the industry & this then puts downward pressure on profits & cash-flow in the cartel
3. the successful entry of non-cartel firms into an industry undermines a cartel’s control of the market
4. the exposure of price-fixing by whistle-blowing firms ie. firms engaged in a cartel that pass on information to the competition authorities in the hope of more lenient treatment from the regulatory competition
   authorities

Question 43

When is competition more likely to happen in an oligopoly ?

Answer 43

1. one firm has lower costs than the others
2. there is a large no. of big firms in the market ➡️ difficult to see what others are doing
3. firms produce very similar products
4. entry barriers are low

Question 44

When is collusion more likely to happen in an oligopoly ?

Answer 44

1. firms have similar costs
2. few large firms in the market ➡️ easier to see what others are doing
3. lots of brand loyalty exists eg. consumers are less likely yo buy from the firm even if their prices are lower
4. entry barriers are high

Question 45

What is informal collusion ?

Answer 45

• a tactic where firms observe one another & decide that it is best for them to not compete on price, so long as the others do the same

Question 46

Collusions and economic efficiency/social welfare ?

Answer 46

• many argue cartels are damaging to economic efficiency & economic welfare
• there are significant penalties for UK businesses found to be engaged in price-fixing cartels & other forms of anti- competitive behaviour:
  1. businesses in breach of competition law can face fines of up to 10% of their worldwide turnover
  2. those convicted of a cartel offence can face up to 5 years of imprisonment, unlimited fines, director disqualification for a period of up to 15 years & potential confiscation of their assets

Question 47

Costs of collusive behaviour ?

Answer 47

1. Damages consumer welfare
   - higher prices / lost consumer surplus
   - loss of allocative efficiency
   - hits lower income families ie. has a regressive impact
2. Absence of competition hits efficiency
   - X-inefficiencies leads to higher unit costs
   - less incentive to innovate/loss of dynamic efficiency
   - output quotas penalise firms who want to expand
3. Reinforces the cartel’s monopoly power
   - harder for new businesses to enter the market – reduces market contestability

Question 48

Potential Benefits from Collusions ?

Answer 48

1. General industry standards can bring social benefits from
   - pharmaceutical research
   - improved car safety technology
2. Fairer prices for producer cooperatives in lower & middle-income developing countries
   - competing more effectively w/powerful corporations who have monopsony power
   - this may help in reducing rates of extreme income poverty
3. Profits have value – how are they used?
   - R&D – leading to dynamic efficiency
   - higher wages for employees – increased consumption

Question 49

What is game theory ?

Answer 49

• used to model the actual behaviour of businesses in concentrated markets
• the study of how people & businesses behave in strategic situations (i.e. when they consider
  the effect of other people’s responses to their own actions)

Question 50

Key game theory concepts ?

Answer 50

• cooperative outcome: an equilibrium in a game where the players agree to cooperate
• dominant strategy: where a single strategy is best for a player regardless of what strategy other players in the game decide to use
• nash equilibrium: any situation where all participants in a game are pursuing their best possible strategy given the strategies of all of the other participants
• tacit collusion: where firms undertake actions that are likely to minimise a competitive response eg. avoiding price-cutting OR
  firms may end up raising prices but without ever having discussed it or reached a formal
  collusive agreement
• whistle blowing: when one or more agents in a collusive agreement report it to the authorities
• zero sum game: an economic transaction in which whatever is gained by one party must be lost by the other

Question 51

What is the prisoner’s dilemma ?

Answer 51

• a game that illustrates why it is difficult to cooperate, even when in the best interest
  of both parties
• both players are assumed to select their own dominant strategies for personal gain
• eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non-dominant) strategy

Question 52

Evaluating the relevance of game theory ?

Answer 52

• game theory becomes relevant to analysing business decision making when there are relatively few firms
• standard game theory assumes rational agents are looking to maximise their own self-interest
• more complex game theory reveals that people businesses can develop co-operative and/or collaborative behaviours eg. the rise of joint ventures/altruism
• 🔔 Key evaluation point for the exam: Game theory can over-simplify complex decisions, and when there are more than 2 rival firms in a market the degree of complexity increases - many firms fall back on rules of
  thumb when making decisions on price, advertising budgets, production levels & much else beside

Question 53

Winners and loses of price wars ?

Answer 53

Winners:
- regular consumers who will see an increase in consumer surplus
- managers – sales revenues will increase if demand is price elastic (i.e. PED>1) which might lead to higher sales bonuses

Losers:
- shareholders – if a prolonged price wars leads to lower profits
- suppliers – who may get squeezed if a firm uses monopsony power to lower the prices of their supplies eg. farmers have complained that supermarket price wars have led to delays in them getting payment
- smaller firms - who may not be able to absorb possible losses from an intense price war
- the govt - if lower profits causes a decline in corporation tax revenues

Question 54

When does a monopoly occur ?

Answer 54

• pure monopoly: occurs when there is only one firm in the industry ie. 100%
• dominant monopoly: has more than 40% market share
• legal/working monopoly: occurs if a firm has more than 25% of the market share eg. British gas
• natural monopoly: occurs when the most efficient number of firms in an industry in one eg. provision of rail network

Question 55

Characteristics of monopolies ?

Answer 55

• a single supplier that dominates the entire market or very low levels of competition
• price maker ➡️ downward sloping demand curve (AR)
• high barriers to entry/exit preventing new firms entering the market to compete
• product differentiation & advertising ➡️ more desirable = higher price
• economic profit can be made in both SR & LR
• allocative & productively inefficient
• due to the low levels of comp: consumers have little choice, price usually higher than it would be in a competitive market, qnty supplied is lower than in a competitive market, little pressure to innovate/ launch new products/ offer excellent customer service
• aim to maximise profit ie. operate where MR=MC

Question 56

Profit maximisation for a monopolist ?

Answer 56

• has price setting power because they face a downward sloping demand curve
• if AR is falling, MR will be below ➡️ in order to sell an additional unit, a firm is assumed to lower the price of all units sold & not just the marginal unit sold

Question 57

What is a natural monopoly ?

Answer 57

• occurs when a large business can supply a market at a lower price than smaller ones
• a situation in which there cannot be more than one efficient provider of a good ➡️ industry where the min efficient scale is a large share of market demand

Question 58

How is a natural monopoly different from other industries ?

Answer 58

• A natural monopoly is a special case where one large business can supply the entire market
  at a lower unit cost than with multiple providers
• This is because of the nature of costs in a
  natural monopoly industry. Typically there
  are very high fixed costs and low marginal costs.
• eg. the supply of water or electricity to
  houses and businesses involves building a big
  network infrastructure
• As a result, fixed costs are enormous but the
  marginal cost of adding an extra user is very low
• Therefore, the average total cost will continue
  to fall as extra users are added to the network.
  This is an internal economy of scale.
• This means that long run average cost (LRAC)
  may fall across all ranges of output. Only one firm
  might reach the minimum efficient scale.

Question 59

What is price discrimination ?

Answer 59

• when businesses charged different consumers different prices for the same good/service
• several types of discrimination:
  1st degree: charging different prices for each individual unit purchased (ie. people pay their own individual willingness to pay)
  2nd degree: prices varying by quantity sold (e.g. bulk purchase discounts) + prices varying by time of purchase (e.g. peak-time prices)
  3rd degree: charging different prices to groups of consumers segmented by price elasticity of demand, income, age, sex

Question 60

Examples of price discrimination ?

Answer 60

• mobile phone contracts/tariffs
• taxi fares at peak times of the day
• cinema ticket prices
• hairdresser discounts
• educational bursaries
• student/retirement prices

Question 61

Aims of price discrimination?

Answer 61

• increase TR (turning consumer surplus into producer surplus)
• increase total profits (providing marginal profit from selling to customers is positive)
• generate cash flow (especially during a recession)
• increase market share + build consumer loyalty
• to more more efficient use of a firm’s spare capacity
• to reduce the amount of waste + cut costs of keeping products in stock/storage