3.4 Market Structures

Question 1

When is allocative efficiency achieved?

Answer 1

When resources are used to produce goods and services which consumers want and value most highly and social welfare is maximised. It will occur when the value to society from consumption is equal to the marginal cost of production, where​ P=MC

Question 2

When does a firm have productive efficiency?

Answer 2

When its products are produced at the lowest average cost - meaning it is maximising output from its inputs. This can only exist if firms produce at the bottom of the AC curve. It is only possible if there is technical efficiency, where the firm uses the most efficient combination of resources

Question 3

When does a firm achieve dynamic efficiency?

Answer 3

When a firm improves efficiency over time through investment, innovation and technological progress. The alternative is static efficiency: efficiency at a set point in time, e.g allocative and productive efficiency. Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws. Supernormal profit is required to provide firms with the incentive to invest and the ability to do so

Question 4

What is X-inefficiency?

Answer 4

● X-inefficiency happens when a firm produces at a higher cost than necessary. The firm is inside the AC curve, not on it
● Caused by waste, poor management, lack of motivation
● Often occurs in monopolies or firms with little competitive pressure, where there’s no incentive to cut costs

Question 5

What determines prices for goods in a perfectly competitive market?

Answer 5

Demand for the firm’s goods is perfectly elastic, prices are solely determined by interaction of demand and supply; the firms are ​price takers​.

Question 6

What are four key characteristics of a perfectly competitive market?

Answer 6

● There must be ​many buyers and sellers
● There must be ​freedom of entry and exit from the industry
● There must be ​perfect knowledge
● The product must be ​homogenous

Question 7

How much do firms in perfect competition make in the long run?

Answer 7

Firms in perfect competition can only make ​normal profit in the long run

Question 8

What type of efficiency is seen in a market with perfect competition?

Answer 8

Perfect competition is ​productively efficient​, since they produce where MC=AC. They are also ​allocative efficient since they produce where P=MC

However, they are ​not dynamic efficient​. No single firm will have enough for research and development. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no competitive benefit. Governments tend to have to do all the research

Question 9

What is monopolistic competition?

Answer 9

A market structure that combines features of both perfect competition and monopoly

It’s common in real-world markets, e.g. restaurants, clothing brands, hairdressers

Question 10

What are characteristics of monopolistic competition?

Answer 10

● A ​large number of buyers and sellers in the market, each of whom are relatively small and act independently, no one buyer or seller has a large price setting power
● There are ​no barriers to entry or exit​, new firms can enter when supernormal profits are being made and leave in the case of losses. As a result, only normal profits are made in the long run.
● Firms produce ​differentiated, non-homogenous goods or services. This means that individual firms do have some price setting power, and so the curve is downward sloping
● Imperfect information. Consumers don’t have perfect knowledge, often influenced by advertising, branding

Question 11

What is an oligopoly?

Answer 11

Where there are a few firms that dominate the market and have the majority of market share. There is a high concentration ratio

Question 12

What are four characteristics of an oligopoly?

Answer 12

● Products are generally differentiated
● Firms must be ​interdependent ​(the actions of one firm will directly affect another);
● There are ​barriers to entry
● Supply in the industry is concentrated in the hands of a relatively small number of firms, meaning there is a high concentration ratio​

Question 13

What does concentration ratio measure?

Answer 13

The ​percentage of the total market that a particular number of firms have

Question 14

What is an equation to calculate concentration ratio?

Answer 14

Question 15

What is collusion?

Answer 15

When firms make ​collective agreements that reduce competition

When firms don’t collude, this is a competitive oligopoly

Question 16

Why might firms want to collude?

Answer 16

● If they work together, they could maximise industry profits​.
● Collusion ​reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.

Question 17

Why might firms not want to collude?

Answer 17

● Since collusion is illegal ​and due to the ​risks of collusion​, such as other firms breaking the cartel or prices being set where they don’t want it
● A firm with a ​strong business model and something that ​sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors

Question 18

When does collusion work best?

Answer 18

● When there are a few firms which are all well known to each other
● The firms are not secretive about costs and production methods and the costs and production methods are similar
● They produce similar products
● There is a dominant firm which the others are happy to follow
● The market is relatively stable
● There are high barriers to entry

Question 19

What is the difference between overt and tacit collusion?

Answer 19

Overt collusion is when firms come to a formal agreement whilst tacit collusion means there is no formal agreement

Question 20

What is a formal collusive agreement called?

Answer 20

A cartel

Question 21

What is a cartel?

Answer 21

A group of firms who enter into agreement to mutually set prices. The rules will be laid out in a ​formal document. Firms who break these rules will experience retaliation from the other members: price wars, charge fines (informally) cutting them out of future deals etc

Question 22

What are the two ways that cartels could operate?

Answer 22

● Agree on a price for the goods and then compete freely using non-price competition to maximise their market share
● Agree to divide up the market ​according to the present market share of each business (limit the quantity of goods/services they produce/supply to create artificial scarcity)

Question 23

What is a major problem in cartels?

Answer 23

There is ​constant temptation to break the cartel​. The more successful the cartel, the greater the incentive to break it; it is important for firms to be the first to break it and not the firm who is left to deal with the after effects

Question 24

As collusion is illegal, what might many firms be involved in instead of a cartel?

Answer 24

Tacit collusion such as price leadership and following a barometric firm

Question 25

What is price leadership?

Answer 25

● Where one firm has advantages due to its size or costs and becomes the dominant firm ● Other firms will tend to follow this firm because they would be fearful of taking the firm on in any form of price war ● As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price.

Question 26

What is barometric firm price leadership?

Answer 26

Where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their lead

Question 27

What does game theory explore?

Answer 27

The ​reactions of one player to changes in strategy by another player ## Footnote The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets

Question 28

What is a Nash equilibrium?

Answer 28

Where neither player is able to improve their position and has optimised their outcome based on the other players expected decision. They have no incentive to change behaviour, unless someone else changes theirs.

Question 29

What is a dominant strategy?

Answer 29

A strategy that is best for a player regardless of what the other players strategy is - guarntees best outcome (If the maximin and maximax strategies end up with the same solution) ## Footnote They aren’t that common in real life and the best strategy for a firm tends to depend on what the other firm does

Question 30

What is a maximin policy?

Answer 30

Involves firms working out the strategy where the worst possible outcome is the least bad

Question 31

What is a maximax policy?

Answer 31

Involves firms working out the policy with the best possible outcome

Question 32

What happens during a price war? what is a result of this?

Answer 32

● A price war will drive prices down to ​levels where firms are frequently making losses ● In the short term, firms will continue to produce if their AVC is below AR ● But in the long run, they will ​leave the market and prices will have to rise since supply falls ● It ​lowers industry profits​.

Question 33

What type of markets are price wars likely to occur in?

Answer 33

● Markets where ​non-price competition is weak​ ● Where goods have weak brands and consumers are price conscious. ● They also occur when it is ​difficult to collude

Question 34

When is predatory pricing likely to occur?

Answer 34

When an established firm is threatened by a new entrant, or if one firm feels that another is gaining too much market share

Question 35

What happens during predatory pricing?

Answer 35

● The established firm will set such a ​low price that other firms are unable to make a profit and will be ​driven out the market ● The existing firm is then able to ​put their price back up.

Question 36

Why is predatory pricing hard to do?

Answer 36

● It is ​illegal ● Only works when one firm is large enough to be able to have low prices and ​sustain losses

Question 37

What is limit pricing and how/why is it done?

Answer 37

● In order to prevent new entrants​, firms will set prices low (the limit price) ● The price needs to be high enough for them to make at least normal profit ​but low enough to discourage any other firm from entering the market. ● It is mainly used in contestable markets (with lower barriers to entry)

Question 38

What is a drawback of limit pricing?

Answer 38

It means firms cannot make profits as high as they would be otherwise be able to

Question 39

What are some forms of non-price competition?

Answer 39

● Advertising ● Loyalty cards ● Branding ● Quality ● Customer service ● Product development

Question 40

How can advertising make a firm more competitive?

Answer 40

● Creates an awareness of the company/product and can persuade a customer to purchase the product. ● Successful advertising, can increase sales and market share for a business , in the long run can increase profits. ● Advertising can also make the demand for a product/service more inelastic.

Question 41

How can loyalty cards make a firm more competitive?

Answer 41

●Encourage repeat purchases by rewarding customers for their loyalty. ● They also provide firms with lots of data on consumers’ buying habits, which the firm can use to increase sales

Question 42

How can branding make a firm more competitive?

Answer 42

● A successful brand can help increase loyalty and repeat purchases for a business. ● People will trust the brand and the quality it represents so will likely keep buying from them ● An established brand should find it easier to release new products

Question 43

How can quality make a firm more competitive?

Answer 43

● A firm that is known for good quality may be able to charge higher prices ● Likely to have strong brand loyalty ● They are likely to have good reputation and benefit from positive recommendations

Question 44

How can customer service make a brand more competitive?

Answer 44

● Encourages loyalty amongst customers ● Gives the business a more positive reputation

Question 45

How can product development make a brand more competitive?

Answer 45

● A business that invests in product development will have a competitive advantage over rivals. ● If they're the first firm to release a new product, they would see an increase in sales and this is likely to help with branding

Question 46

What is a pure monopoly?

Answer 46

Exists where one firm is the ​sole seller of a product in a market

Question 47

What is one of the closest examples to a pure monopoly?

Answer 47

Google, who have 88% of the market

Question 48

How much of the market do google have a share of?

Answer 48

88%

Question 49

When can a firm be legally considered as having monopoly power? ## Footnote (by the CMA)

Answer 49

If it has ​more than 25% of the market/industry's sales

Question 50

What is third degree price discrimination?

Answer 50

Charging different prices for the same good or service in different segments of the market. Price charged is linked directly to consumers' willingness and ability to pay for a good or service ## Footnote e.g different times of the day (peak and off-peak train times), different prices in different places (London and smaller towns), between different incomes, (discounts for elderly people/students)

Question 51

What must happen for third degree price discrimination to work?

Answer 51

● The firm must be able to clearly ​separate the market into groups of buyers ● The customers must have ​different elasticities of demand​ ● They must be able to ​control supply and prevent buyers from the expensive market from buying in the cheaper market

Question 52

What are some of the benefits to firms and consumers of third degree price discrimination?

Answer 52

● Firms are able to increase their profits​. This can go into research and development, improving dynamic efficiency. ● Those in the elastic market gain as they are able to pay a lower price than they otherwise would; they benefit from cross subsidisation. These consumers may have been unable to access the good if it were not for the price discrimination and so this may ​increase equality

Question 53

How can consumers be negatively affected by third degree price discrimination?

Answer 53

● Some consumers have to pay a ​higher price, lowering their consumer surplus

Question 54

What is a natural monopoly?

Answer 54

When one large firm can supply the entire market at a lower long run average cost than if the market was split up into multiple providers ## Footnote Typically, there are very high fixed costs and low marginal costs

Question 55

What are the benefits of being a monopoly to the firm?

Answer 55

● Potential to make ​huge profits for their shareholders through profit maximisation ● The existence of supernormal profits means firms will have finance for investments and will be able to build up ​reserves to overcome short term difficulties​ ● Firms with monopoly power will be able to ​compete against large overseas organisations​. ● Large firms will be able to maximise economies of scale, reducing costs and increasing profit further

Question 56

Why might a monopolistic firm not choose profit maximisation?

Answer 56

● Because of X-inefficiencies, sales or revenue maximising, profit satisficing or contestability leading to limit pricing ● In the long run, the lack of competition ​may mean that firms become complacent and so they may not make maximum profits

Question 57

What are potential benefits of a monopoly to employees?

Answer 57

● The ​inefficiency of the monopoly may mean employees receive higher wages, particularly directors and senior managers ● Profit satisficing or sales/revenue maximising may mean output is higher and so more employees are employed

Question 58

What are benefits of a monopoly to consumers?

Answer 58

● With a ​natural monopoly​, consumers tend to be better off than if there was competition. ● When firms enjoy ​economies of scale​, they will be more efficient and customers will enjoy a higher consumer surplus ● Monopolists may produce an ​increased range of goods or services due to cross subsidisation. ● The use of price discrimination will allow for ​survival of a product or service​, and benefits some customers (those in the cheap market) whilst is negative for others. For example, it is said that​ economy class flights are funded by business class flights

Question 59

What are negative effects of a monopoly on consumers?

Answer 59

● Consumers may pay ​higher prices and see a ​poorer quality service​, due to a lack of competition ● There is ​less choice​ for consumers, since there is only one firm producing the good ● The use of price discrimination will allow for ​survival of a product or service​, and benefits some customers (those in the cheap market) whilst is negative for others. For example, it is said that​ economy class flights are funded by business class flights

Question 60

How efficient are monopolies?

Answer 60

● Productively inefficient, ​since they don’t produce at MC=AC. ● They are also ​not allocative efficient​ as P>MC. ● Since a monopolist is likely to make supernormal profits, they will be ​dynamically efficient.​ However, if there is no competition, they may have no incentive to invest.

Question 61

What is a monopsony?

Answer 61

● When a single buyer controls the market for a particular good or service ● In essence setting price and quality levels, normally because without that buyer there would not sufficient demand for the product to survive

Question 62

What are characteristics of a contestable market?

Answer 62

● Perfect knowledge, so if one firm is making abnormal profits, other firms will enter the market ● Freedom of entry and exit, any firms can enter/leave the market. There will be a ​relative absence of sunk costs. Firms will be able to and have the legal right to use the best available technology​, meaning their average cost curve will be the same as the original firms’. ● Low product loyalty​, meaning people don’t consistently use one brand and are happy to switch if a new one enters the market. ● We assume firms are short run profit maximisers and do not collude with each other

Question 63

What are implications of a contestable market?

Answer 63

● Firms will enter the market if they see other firms making huge profits. They will remain in the market until competition prevents them from making a profit. This will take away profit from the original firms, and could even force them out of business. The only way to prevent this is by using ​limit pricing​, which reduces the incentive for firms to enter the market. ● Firms will only be able to make ​normal profits and produce where AC=AR as new firms will enter the market if price was any higher and they were making monopoly profits

Question 64

What is efficiency like in contestable markets?

Answer 64

● Firms are likely to be ​productive and allocative efficient. If they are not producing at the lowest point on their AC curve, new firms can enter the market and undercut them by offering lower prices ● Due to this, and the fact they can only make normal profits in the long run, they must also be allocative efficient. Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC. Therefore, AC=MC=AR, so the value to society is equal to the cost

Question 65

What are natural barriers to entry sometimes called?

Answer 65

​Innocent entry barriers

Question 66

How can legal barriers prevent new firms from entering an industry?

Answer 66

●Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter ● For example, ​patents and exclusive rights to production (e.g. with television) mean other firms cannot enter the market​ ● Some industries, such as the taxi industry, gain market licences to operate​

Question 67

How can marketing barriers make firms less likely to enter an industry?

Answer 67

● High levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands ● Sometimes a brand can become associated with a product, such as ​‘Hoover’ with vacuum cleaners​ ● New firms entering the industry are unlikely to have the funds to undertake large scale advertising so struggle to compete with the incumbent firms ## Footnote This may also be a barrier to exit, since losing a brand and consumer loyalty will be a cost of leaving the market

Question 68

What are incumbent firms?

Answer 68

● Businesses already established in each market or industry ● They may have the advantages of having built up a loyal base of customers and also achieved internal economies of scale so that their average costs are lower than those of a rival/challenger supplier or brand

Question 69

How can the ​pricing decisions of incumbent firms be a barrier to entry?

Answer 69

● Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter ● Limit pricing discourages the entry of other firms as prices are set at a level to prevent new entrants ● Some firms might employ anti-competitive practices, such as refusing to supply retailers which stock competitors

Question 70

What are some examples of barriers to exit?

Answer 70

● Barriers to exit prevent firms from leaving a market quickly and cheaply ● They include the ​cost to write off assets, pay leases and make workers redundant​

Question 71

How can economies of scale be a barrier to entry?

Answer 71

● New firms are unable to produce on the same AC curve as large, incumbent firms. ● If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete

Question 72

What is a sunk cost?

Answer 72

● A ​fixed cost that a business cannot recover if it leaves the industry ● It includes ​property (if the lease is longer than it is actually used for), machinery and equipment that cannot be resold, and advertising​

Question 73

How is the degree of contestability measured?

Answer 73

● The ​extent to which the gains from market entry for a firm exceed the costs of entering the market​ ● A market with no sunk costs and no barriers to entry and exit is a perfectly contestable market ● The more contestable a market, the more unstable it will be as there can be regular hit and run competition

Question 74

How stable are contestable markets?

Answer 74

The more contestable a market, the more unstable it will be as there can be regular hit and run competition