Chapter 5

Question 1

Define perfect competition.

Answer 1

There are very many firms competing. Each firm is so small relative to the whole industry that it has no power to influence price. It is a price taker.

Question 2

Define monopolistic competition.

Answer 2

There are quite a lot of firms competing and there is freedom for new firms to enter the industry.

Question 3

Define a monopoly.

Answer 3

Just one firm in the industry and hence no competition from within the industry.

Question 4

Define an oligopoly.

Answer 4

There are only a few firms and where entry of new firms is restricted.

Question 5

Which 3 factors should you consider to help distinguish between competition?

Answer 5

1. How freely can firms enter the industry?
2. The nature of the product (e.g., identical or different brands/models?)
3. The degree of control the firm has over price. (i.e., what is the nature of the demand curve it faces?)

Question 6

How does the market structure a firm operates in affect its behaviour and performance?

Answer 6

The market structure will affect the firms behaviour (i.e., “conduct”) which will then affect the firm’s performance: e.g., prices, profits, etc. It can also affect the performance of other firms. Thus, structure -> conduct  performance.

Question 7

Define imperfect competition.

Answer 7

The collective name for monopolistic competition and oligopoly.

Question 8

What are the four assumptions of perfect competition?

Answer 8

1. Firms are price takers and have no ability to affect the price of the product. Firms face a horizontal demand curve at the market price.
2. There is complete freedom of entry. Setting up in business takes time however, so freedom of entry applies in the long run.
3. All firms produce an identical product. There is therefore no branding or advertising.
4. Producers and consumers have perfect knowledge of the market.
   This is a very rare market. Certain agricultural markets perhaps come close to this.

Question 9

Define the short run under perfect competition.

Answer 9

We assume the number of firms in the industry cannot be increased: there is simply not time for new firms to enter the market.

Question 10

What is the short-run supply curve under perfect competition?

Answer 10

The firms short-run supply curve will be its (short-run) marginal cost curve. But why? A supply curve shows how much will be supplied at each price: it relates quantity to price. The marginal cost curve relates quantity to marginal cost. But, under perfect competition, given that P = MR and MR = MC, P must equal MC. Thus, the supply curve and the MC curve will follow the same line. So, under perfect competition, the firm’s supply curve depends entirely on production costs. This demonstrates why the firm’s supply curve is upward sloping. Since marginal costs rise as output rises (due to diminishing marginal returns), a higher price is necessary to induce the firm to increase its output. Note that the firm will not produce at a price below average variable cost (AVC). Thus, the supply curve is only that portion of the MC curve above point e. What will be the short-run supply curve of the whole industry? This is simply the sum of the short-run supply curves (and hence MC curves) of all the firms in the industry. Graphically, it will be a horizontal sum, since it is quantities that are being added.

Question 11

Define the long run under perfect competition.

Answer 11

In the long-run under perfect competition, if typical firms are making supernormal profits, new firms will be attracted to the industry. Also, if existing firms can make more profit by increasing their size they will. The effect of this is to increase industry supply. The industry supply curve will thus shift to the right has new firms enter. This can cause prices to fall. Supply will go on increasing and prices falling until firms are only making normal prices. This will be when the price has fallen to the point where the demand curve for the firm just touches the bottom of its long-run average cost curve.

Question 12

Why is perfect competition and economies of scale so incompatible?

Answer 12

1. Firms have to be quite large if they are to experience the full potential economies of scale. But perfect competition requires there to be many firms.
2. Once a firm expands sufficiently to achieve economies of scale, it will usually gain market power. Thus, it can undercut the prices of smaller firms, which will be driven out of business. Thus, perfect competition is destroyed.
   Therefore, perfect competition can only exist in any industry if there are no economies of scale.

Question 13

What are 3 things that make perfect competition good for consumers?

Answer 13

1. Price equals marginal cost. This means production levels are “just right”.
2. The combination of (long-run) production being at a minimum average cost and the firm making only normal profit keeps price at a minimum.
3. Perfect competition is a case of “survival of the fittest”. This encourages firms to be efficient & to invest in new, improved technology where possible.

Question 14

Describe the assumptions of perfect competition in relation to e-commerce.

Answer 14

1. Large number of firms – the reach of the internet is global. Firms’ demand curves are thus becoming very elastic.
2. Perfect knowledge. E-commerce adds to the consumers knowledge (e.g., there is greater price transparency, with consumers able to compare prices online).
3. Freedom of entry – internet companies often have lower start up costs than their conventional rivals. Marketing costs can also be relatively low. Internet companies are often smaller and more specialist, relying on Internet “outsourcing”. They are also more likely to use delivery firms than having their own transport fleet.

Question 15

Why is it difficult to determine if a firm is a monopoly?

Answer 15

To some extent, the boundaries of an industry are arbitrary (e.g., an industry has a monopoly on certain types of fabric, but not on fabrics in general). It is more important to consider the amount of monopoly power a firm has, and that depends on the closeness or substitutes produced by rival industries (e.g., electricity is a monopoly).

Question 16

Describe 9 barriers to entry that relate to monopoly.

Answer 16

1. Economies of scale. Natural monopoly occurs where long-run average costs would be lower if an industry where under monopoly than if it were shared between two or more competitors. (e.g., electricity transmission). This is more likely if the industry is small. If the industry could support more than one firm, a new entrant is likely to struggle to start up on a very large scale. i.e., the monopolist could charge very low prices and drive the new firm out of business.
2. Network economies. When a product or service is used by everyone in the market, there are benefits to all users from having access to other users (e.g., ebay).
3. Economies of scope. A firm that produces a range of products is also likely to experience a lower average cost of production. These lower costs make it difficult for a new single-product entrant to the market, since the large firm will be able to undercut its price and drive it out of the market.
4. Product differentiation and brand loyalty. If a firm produces a clearly differentiated product, where the consumer associates the product with the brand, it will be very difficult for a new firm to break into that market (e.g., Xerox).
5. Lower costs for an established firm. An established monopoloy is likely to have developed specialised production and marketing skills. It is likely more aware of the most efficient techniques and the most reliable/cheapest suppliers. It will probably have access to cheaper finances. Overall, it will be operating on a lower cost curve.
6. Ownership of, or control over, key inputs or outputs. If a firm governs the supply of vital inputs it can deny potential rivals access to these inputs. Similarly, if a firm controls the outlets through which the product must be sold it can prevent potential rivals from gaining access to consumers.
7. Legal protection. A firm’s monopoly position may be protected by patents, various forms of licensing and tariffs (i.e., customs duties), and other trade restrictions to keep out foreign competition.
8. Mergers and takeovers. The monopolist can put in a takeover bid for any new entrant. The sheer threat of takeover may discourage new entrants.
9. Aggressive tactics. An established monopolist can probably sustain losses for longer than a new entrant. Thus it could start a price war, mount massive advertising campaigns, etc.

Question 17

What happens to equilibrium price and output in a monopoly?

Answer 17

Since there is only one firm, the firm’s demand curve is also the industry demand curve.
Demand under monopoly tends to be less elastic at each price than other markets. If the price increases consumers have nobody else to turn to. Thus, the monopolist is a price maker and can choose what price to charge. Nevertheless, it is still constrained by its demand curve. A rise in price will reduce the quantity demanded.
A monopolist will maximise profit where MR = MC. Profits tend to be larger when the demand curve is less elastic (and hence the MR curve is steeper), and thus the gap between MR and price (AR) is bigger. The actual elasticity will depend on whether reasonably close substitutes are available in other industries.

Question 18

In the short run, does monopoly or perfect competition best serve the public interest?

Answer 18

In the short run it would seem that (other things being equal) perfect competition serves the public interest better.

Question 19

In the long run, does monopoly or perfect competition best serve the public interest? How do costs affect this?

Answer 19

It is easy to assume that, other things being equal, long-run prices will tend to be higher, and output lower, under monopoly. If we consider the issue of costs, the following points apply:
1. As the monopolist does not have competition it can make large profit without using the most efficient techniques. (i.e., it has less incentive to be efficient). Thus, costs may be higher under a monopoly.
2. However, a monopoly may be able to achieve substantial economies of scale due to larger plant, centralised administration, etc. Thus, monopoly may produce a higher output at a lower price.
3. Although monopolist may not have the incentive to become more efficient, it will have more ability as it has access to more funds.
4. Although a monopoly does not have competition in the goods market, it may face competition in financial markets. I.e., if run inefficiently it may be at risk of a takeover (called competition for corporate control).
5. The promise of supernormal profits that may be protected by patents may encourage monopolies to produce/develop new products.

Question 20

Describe “potential competition”.

Answer 20

What makes something a monopoly is whether there is the real threat of competition. i.e., the threat of competition has a similar effect to actual competition.

Question 21

Define a “perfectly contestable market”

Answer 21

Where the costs of entry and exit by potential rivals are zero, and such entry can be made very rapidly. Thus, the sheer threat of this happening will:
1. Ensure firms in the market will keep prices down so they can continue to make normal profits
2. Produce as efficiently as possible.

Question 22

Why are markets “contestable and natural monopolies” rather than “perfectly contestable”?

Answer 22

1. To be efficient, the firm may have to be so large relative to the market that there is only room for one such firm.
2. However, if there are no entry/exit costs new firms will be willing to enter if they believe they would be more efficient than the existing firm. Thus, the existing firm will be forced to produce as efficiently as possible and only with normal profit.

Question 23

Why is a costless exit important?

Answer 23

1. If costs are substantial and cannot be transferred to other uses (e.g., machinery) these are sunk costs. This will deter firms from entering.
2. If capital equipment can be transferred, new firms will be more willing to take the risk.
   Therefore, the lower the exit costs, the more contestable the market.