3.4 Market structures

Question 1

Allocative efficiency

Answer 1

Allocative efficiency occurs when resources are allocated in a way that maximizes overall societal welfare or utility. In a perfectly competitive market, allocative efficiency is achieved when the price of a good or service equals its marginal cost (P = MC), meaning that the market is producing the quantity of the good that maximizes consumer and producer surplus.

Question 2

Productive efficiency

Answer 2

When firms have chosen appropriate combinations of facotrs of production and produce the maximum utput from those outputs, thus producing at the minimum long-run average cost. In competitive markets, productive efficiency is realised when firms produce at the minimum point of their average cost curve (AC = MC).

Question 3

Dynamic efficiency

Answer 3

Dynamic efficiency refers to the ability of an economy to innovate and adapt over time. It involves the long-term competitiveness and growth potential of an economy. Dynamic efficiency is linked to innovation, technological progress, and the ability to adapt to changing circumstances.

Question 4

X-inefficiency

Answer 4

X-inefficiency occurs when a firm is not operating at its lowest possible cost, even in the absence of competitive pressures. This inefficiency can arise due to factors such as poor management, lack of motivation, or the absence of competition. X-inefficiency can persist in markets where firms have market power.

Question 5

Efficiency/Inefficiency in Different Market Structures

Answer 5

Perfect Competition: In a perfectly competitive market, allocative and productive efficiency are typically achieved because firms are price takers and have no market power. Resources are allocated efficiently, and firms produce at minimum cost. Not as many profits so restrains DE, however it is a very competitive market.
Allocative efficiency will be achieved in the sr, and productive efficiency will only be achieved in the lr.
Monopoly: Monopolies often lead to allocative inefficiency because they can set prices above marginal cost, resulting in deadweight loss. However, a monopoly can be productively efficient if it operates at the minimum point of its average cost curve.
Monopolistic Competition: In this market structure, firms may not achieve allocative efficiency because they have some degree of market power, but they compete on product differentiation. Productive efficiency may not be fully realized either, as firms may operate at less than minimum average cost due to product differentiation.
Oligopoly: Oligopolistic firms can engage in price competition, leading to allocative inefficiency. However, they may invest in research and development, contributing to dynamic efficiency. Whether productive efficiency is achieved depends on the specific industry.
Mixed or Regulated Markets: In some industries, governments may intervene to promote allocative and productive efficiency through regulations, subsidies, or antitrust policies.

Question 6

Characteristics of Perfect Competition

Answer 6

Large Number of Sellers: In a perfectly competitive market, there are many sellers, each of whom is too small to influence the market price through their individual actions.
Homogeneous or Identical Products: Firms in perfect competition produce identical or homogeneous products that are perfect substitutes for each other. Consumers perceive no difference between the products of different sellers.
Perfect Information: Both buyers and sellers have access to perfect and complete information about the market, including prices, product quality, and production techniques. This ensures transparency and prevents information asymmetry.
Free Entry and Exit: Firms can enter or exit the market without any barriers. There are no significant obstacles such as high entry costs or government regulations that prevent firms from entering or leaving the industry.
Price Takers: Individual firms in perfect competition are price takers, meaning they cannot influence the market price. They must accept the prevailing market price as given and adjust their production accordingly.
Zero Long-Run Economic Profit: In the long run, firms in perfect competition earn zero economic profit. Economic profit is just enough to cover all costs, including opportunity costs of capital.
Perfect Mobility of Resources: Resources, including labor and capital, can easily move in and out of different firms or industries without restrictions, ensuring efficient allocation.
Non-Collusive Behavior: Firms do not engage in collusion or cooperative behavior. They compete vigorously against each other.

Question 7

Profit Maximizing Equilibrium in the Short Run perfect competition

Answer 7

In the short run, a firm in perfect competition seeks to maximize its profit or minimize its loss. To determine the profit-maximizing output and price in the short run, a firm compares its marginal cost (MC) with the market price (P). The short-run profit maximization rule is as follows:
If MC < P, the firm should increase its output because producing one more unit adds more to revenue than to cost.
If MC > P, the firm should decrease its output because producing one more unit adds more to cost than to revenue.
If MC = P, the firm is maximizing its profit at the current output level.
The firm will produce as long as P covers the average variable cost (AVC). If P is greater than or equal to AVC but less than average total cost (ATC), the firm will continue to produce in the short run, even if it incurs a loss.

Question 8

Profit Maximizing Equilibrium in the Long Run perfect competition

Answer 8

In the long run, firms in perfect competition adjust to reach a state of zero economic profit. This involves:

If firms are making economic profit in the short run, new firms will enter the market due to the absence of entry barriers. This increases supply, lowers prices, and reduces the profits of existing firms.
If firms are incurring economic losses in the short run, some firms will exit the market, reducing supply, raising prices, and allowing remaining firms to potentially cover their costs.
This process continues until all firms in the industry earn only normal profit, where P = ATC. In the long run equilibrium, no firm is making economic profit or incurring economic losses, and resources are efficiently allocated.

Question 9

Profit maximising output level - firm making surplus profits perfect comp diagram

Answer 9

Question 10

Two ways of finding profit maximising output level for perfect competition

Answer 10

MC=MR
TR>TC by the greatest amount

Question 11

Perfect competition firm making sr losses diagram

Answer 11

Question 12

Shutdown point sr + lr perfect competition

Answer 12

The marginal cost curve above AVC in sr
The MC curve above AC curve in lr

Question 13

The industry’s short run/long run supply curve shutdown point perfect comp.

Answer 13

The horizontal summation of the MC curves above AVC/AC

Question 14

Monopolistic competition characteristics

Answer 14

Many Sellers: There are numerous firms in the market, each producing slightly differentiated products. These differences can be based on branding, quality, design, or other factors.
Product Differentiation: Each firm produces a product that is similar but not identical to the products of its competitors. This product differentiation allows firms to have some control over the price they charge.
Easy Entry and Exit: Firms can enter or exit the market relatively easily. There are no significant barriers to entry, such as high startup costs or government regulations.
Non-Price Competition: Firms engage in non-price competition to attract customers. This includes advertising, product design, branding, and customer service.
Firms have control over the product’s price
Short-Run and Long-Run Profits: In the short run, firms may earn economic profits or incur losses. In the long run, however, economic profits tend to be eroded as new firms enter the market or existing firms adjust their products and strategies.
Perfect knowledge - If surplus profits are being made, new firms will be attracted into the industry

Question 15

Monopolistic competition profit maximising sr

Answer 15

In the short run, a monopolistically competitive firm maximizes its profit by producing the quantity of output where marginal cost (MC) equals marginal revenue (MR), and setting a price based on its perceived demand curve. Here’s how it works:
Determine the marginal cost (MC) and marginal revenue (MR) for the firm.
Find the quantity of output where MC equals MR.
Set the price based on the demand curve corresponding to that quantity.
If the price exceeds average total cost (ATC) at this profit-maximizing quantity, the firm will earn economic profit. If the price is less than ATC but greater than AVC (average variable cost), the firm will incur losses but continue to produce in the short run. If the price falls below AVC, the firm will shut down temporarily.

Question 16

Monopolistic competition profit maximising lr

Answer 16

In the long run, monopolistically competitive firms face competition and have the flexibility to adjust their product characteristics, prices, and production levels. Here’s what happens in the long run:

If a firm is making economic profits, new firms will be attracted to the market due to its attractiveness. This will increase competition.
As more firms enter, the demand for each individual firm’s product decreases, leading to a decrease in the demand curve for each firm.
In the long run, the firm’s economic profit will be reduced to zero as the demand curve shifts to the left.
Firms may continue to operate with zero economic profit, as long as they cover their average total costs (ATC).
If firms are experiencing losses, some may exit the market, and the remaining firms may experience a smaller decrease in demand, allowing them to cover their costs.

Question 17

Monopolistic competition lr equilibrium diagram

Answer 17

Question 18

Monopolistic competition sr equilibrium diagram

Answer 18

Question 19

Oligopoly

Answer 19

A market dominated by a few large suppliers

Question 20

Oligopsony

Answer 20

A few buyers in the market

Question 21

Duopoly

Answer 21

Two suppliers in a market

Question 22

Key features of oligopoly

Answer 22

High Barriers to Entry and Exit: Oligopolistic markets often have significant barriers that prevent new firms from entering the industry or existing firms from easily exiting. These barriers can include high capital requirements, economies of scale, patents, and government regulations.
Interdependence of Firms: Oligopolistic firms are highly aware of the actions and decisions of their competitors. They must consider how their own choices, such as pricing and marketing strategies, will affect the behavior and reactions of rival firms.

Question 23

Concentration ratio

Answer 23

Shows the market domination of the top firms in an industry

Question 24

Concentration ratio measures (3)

Answer 24

Market share (most likely)
Employment
Sales

Question 25

Concentration ratio eval

Answer 25

Can be misleading ie a four firm concentration ratio of 80% could be 4 x 20% or 77% +1% + 1% + 1%

Question 26

Collusion

Answer 26

Where two or more firms communicate to act in an anti-competitive manner

Question 27

Tacit/illicit collusion

Answer 27

Involves firms behaving in a manner that resembles collusion without any explicit agreement. Firms may follow observed pricing patterns set by competitors or engage in price leadership, where one dominant firm sets the price and others follow suit

Question 28

Overt collusion

Answer 28

Real verbal or written collusion between firms

Question 29

Cartel

Answer 29

A formal collusive agreement between firms, hoping to maximise profits for all of them. It effectively combines its member firms into a single monopoly decision maker

Question 30

Factors favouring collusion (8)

Answer 30

Few firms in the industry - ensures that firms keep to the agreement due to market monitoring
Similar production methods - change prices at same time as other firms
Production of similar goods - relatively easy to agree on price
One dominant firm
Significant entry barriers - little fear of disruption from new entrants
A stable market - significant swings in demand or costs will make agreements difficult to achieve
An absence of gov legislation to prevent collusion
Firms operating at or near full capacity - less temptation to increase output and undercut the agreement
Minimum efficient scale is not at a low level of output

Question 31

Limit pricing

Answer 31

Agreeing on a price which is the highest that oligopolists can charge without prompting a new entrant to appear

Question 32

Predatory pricing

Answer 32

When a firm sets its prices below its own average cost in order to drive competitors out of business

Question 33

Game theory

Answer 33

Question 34

Reasons for Collusive and Non-Collusive Behavior

Answer 34

Collusive Behavior:
Maintaining High Prices: Firms in an oligopoly may collude to set high prices and limit competition, increasing their profits collectively.
Stability: Collusion can provide market stability, reducing uncertainty for firms and consumers.
Avoiding Price Wars: Collusion helps firms avoid destructive price wars.
Non-Collusive Behavior:
Competition: Firms may choose to compete aggressively to gain market share and increase profits individually.
Legal Constraints: Antitrust laws and regulations prohibit collusion, encouraging firms to compete independently.
Differences in Objectives: Firms may have differing goals and incentives that make collusion difficult.

Question 35

Price wars

Answer 35

Fierce competition where firms continuously lower prices to gain market share, often resulting in reduced profits for all

Question 36

Types of non-price discrimination

Answer 36

Product Differentiation: Firms emphasize the unique qualities and features of their products through branding, quality, design, or advertising.
Advertising and Marketing: Firms engage in extensive advertising and marketing campaigns to create brand loyalty and awareness.
Innovation: Competing through the development of new products, technologies, or processes.
Customer Service: Offering exceptional customer service and support as a competitive advantage.
Distribution Channels: Establishing efficient distribution networks to reach customers faster and more conveniently.

Question 37

Monopoly definition

Answer 37

A sole supplier of a good or service that has no competition

Question 38

CMA definition of monopoly

Answer 38

At least 25% of market share

Question 39

Barriers to entry (7)

Answer 39

• Economies of scale
• Product differentiation - loyalty
• Patents and copyright
• Aggressive tactics such as limit pricing
• R&D expenditure - new firms cannot compete with innovation
• International trade restrictions such as tariffs and quotas
• Capital costs/ sunk costs - cannot be recovered

Question 40

Monopoly Diagram

Answer 40

Question 41

Types of entry barriers (2)

Answer 41

Innocent + deliberate

Question 42

Situations when a monopolist may not profit maximise (2)

Answer 42

• Threat of competition ie limit pricing
• Government ownership/ threat of intervention ie higher taxes or cma intervention

Question 43

Arguments against monopolies (3)

Answer 43

• Less output + higher prices
• Unequal distribution of income - high profits for the firm are gained at the expense of the consumer
• Inefficient outcome - monopolies are usually productively inefficient and x-inefficient and allocatively inefficient

Question 44

X-inefficiency diagram

Answer 44

Question 45

Assumptions for price discrimination (3)

Answer 45

• Firm must be a price maker
• Different PEDs in different markets (otherwise they would be charged the same prices)
• Resale preventable

Question 46

Types of price discrimination (3)

Answer 46

• Time (peak times vs off peak)
• Geographical distance
• Age

Question 47

Monopoly characteristics

Answer 47

Single Seller: In a monopoly, there is only one firm or seller that dominates the entire market, with no close substitutes for its product.
Unique Product: The monopolist typically offers a unique product that has no perfect substitutes. This lack of substitutes gives the monopolist significant control over pricing.
High Barriers to Entry: Monopolies often maintain their dominant position due to high barriers to entry, which can include factors like patents, economies of scale, control over essential resources, and government regulations.
Price Maker: A monopoly has the power to set the price of its product, and it faces a downward-sloping demand curve. It can choose the price and quantity of output to maximize its profits.
Market Power: Monopolies have substantial market power, meaning they can influence market conditions, restrict output, and charge higher prices than would be possible in a competitive market.
Long-Run Profitability: Monopolies can earn long-term economic profits because of their ability to set prices above their production costs

Question 48

Arguments in favour of monopoly

Answer 48

They may gain eos and so prices will be lower
Monopoly is conducive to innovation - more money available + depends on bte
Relatively stable -can take a long time perspective

Question 49

Natural monopoly

Answer 49

A natural monopoly occurs when a single firm can efficiently serve the entire market due to significant economies of scale.
They are subject to a constantly decreasing economies of scale
Key features include:
High fixed costs relative to variable costs.
Declining average total cost as production scales up.
It is often found in industries like utilities (water, electricity) and infrastructure (railways, telecommunications).
Natural monopolies can benefit consumers by providing services at lower costs than multiple competing firms would achieve, but they require regulation to prevent potential abuse of market power.

Question 50

Benefits of price discrimination

Answer 50

May enable production to take place when it would not otherwise do so
Enables firms to spend more on R+D and reinvest profits for greater efficiency (quality up, price down)

Question 51

Negatives of price discrimination

Answer 51

Firms can decide which consumers should pay higher prices - cause problems
May drive competitors out of the market by charging low prices where there is stiff competition ie predatory pricing

Question 52

Price discrimination enabling production to take place diagram

Answer 52

Question 53

Third degree price discrimination diagram

Answer 53

Question 54

Monopsony

Answer 54

Only one buyer in the market

Question 55

Costs and benefits of monopsony for firm, suppliers and consumers

Answer 55

Effect for monopsony firm:
Higher profits by buying at lower prices, thus a downward shift of his/her MC curve
However, if the monopsony exploits its market power excessively, it can harm suppliers, potentially leading to reduced supply, lower product quality, or the exit of smaller suppliers from the market.
Effect for suppliers:
Likely to suffer because their prices fall
May have security of orders
Effect for consumers:
Lower production costs may be passes on in the form of lower prices
Monopsonist can act as a counterbalance to the selling power of a monopolist
Negative for consumers:
However, if the monopsony drives suppliers out of business or reduces the quality of inputs, it could result in limited product variety and potentially higher prices in the long run.
Effect for employees:
Employees may benefit from a monopsony’s presence if it offers competitive wages and working conditions due to its ability to negotiate lower input costs.
However, in cases where the monopsony uses its power to depress wages, it can lead to lower incomes and reduced job opportunities for workers.

Question 56

Characteristics and Conditions for a Monopsony to Operate

Answer 56

Single Buyer: A monopsony is characterized by a single dominant buyer in a particular market or industry. This buyer has substantial market power and controls a significant share of the total demand for a specific product or labour.
Limited Substitute Buyers: A key condition for a monopsony to exist is the absence of readily available substitute buyers for the goods or services it purchases. This limits the options for sellers to find alternative customers.
Price Maker: The monopsonist has the ability to set the price it is willing to pay for the goods or services it buys. It can do so because sellers have limited alternatives, and the monopsonist’s demand significantly affects market prices.
Downward-Sloping Supply Curve: The supply curve facing the monopsonist is downward-sloping, meaning that sellers are willing to provide more goods or services at lower prices. This gives the monopsonist the power to negotiate lower prices with suppliers.
Barriers to Entry: In some cases, barriers to entry or factors that discourage new buyers from entering the market may contribute to the existence of a monopsony. These barriers could include regulatory restrictions, high startup costs, or economies of scale that favour larger buyers.

Question 57

Polices to address monopsony power

Answer 57

Industry regulation + fines
Competition policy (CMA)
Establishing co-operatives among smallholder farmers
Tougher industry standards on ethical sourcing of raw materials
Using technology to sell directly to consumers + not need to sell to an intermediary
Minimum price

Question 58

Monopsony power examples

Answer 58

Supermarkets, NHS, governement

Question 59

Blocked monopoly merger example

Answer 59

Sainsbury + Asda, 2019

Question 60

Characteristics of contestable markets

Answer 60

Low Barriers to Entry: In a contestable market, there are low barriers to entry for new firms. This means that it is relatively easy for new companies to enter the market and compete with existing firms. Barriers to entry could include factors like high startup costs, government regulations, or control over essential resources.
Low Barriers to Exit: Similarly, contestable markets have low barriers to exit. Firms can exit the market without incurring substantial costs or facing significant obstacles. This encourages firms to enter and exit the market based on changes in profit opportunities.
Perfect Information: In a contestable market, both existing and potential entrants have access to perfect information about market conditions, including prices, costs, and demand. This transparency ensures that firms can make informed decisions about entering, exiting, or adjusting their production levels.
No Sunk Costs: Sunk costs are costs that cannot be recovered once incurred. In contestable markets, firms are assumed not to have significant sunk costs. This means they can exit the market without suffering substantial financial losses, which makes the market more contestable.
Freedom of Entry and Exit: Firms in contestable markets can enter and exit freely without facing legal or regulatory restrictions. This freedom allows for dynamic competition as firms can respond quickly to changes in market conditions.
No Collusion: Collusion between firms to
maintain monopoly power is less likely in contestable markets due to the ease of entry and exit. Firms know that if they try to raise prices or restrict output, new competitors can quickly enter and undercut them.

Question 61

Implications of contestable markets for the behaviour of firms:

Answer 61

Price Competition: Firms in contestable markets tend to engage in intense price competition since they know that new entrants can easily undercut their prices if they attempt to charge excessive prices.
Efficiency and Innovation: Firms have an incentive to operate efficiently and innovate to maintain a competitive edge. In a contestable market, the threat of new entrants drives firms to continually improve their products and processes.
Short-Term Focus: Firms may have a short-term focus on maximizing profits since they are aware that the market conditions can change rapidly with the entry of new competitors.
No Monopoly Power: Contestable markets discourage firms from attempting to establish and maintain monopoly power since any attempt to do so is likely to be short-lived.

Question 62

Hit and run competition

Answer 62

When firms can enter a market at low cost attracted by high profits and then leave the market at low cost when profits fall

Question 63

Contestable market

Answer 63

A market where there is freedom of entry to the industry and where costs of exit are low

Question 64

Monopoly negative diagram

Answer 64

Question 65

Monopoly EOS vs smaller firm diagram

Answer 65