L1 Flashcards
What are the assumptions of perfect competition as the industry benchmark? (8)
What are the assumptions of perfect competition as the industry benchmark?
- Large number of firms, each with no market power (i.e., their output decisions do not affect market price).
- Homogeneous products.
- Long-run average cost (LRAC) is small in relation to market demand.
- All firms are price takers, meaning the demand curve facing an individual firm is perfectly elastic.
- Perfect information among consumers and producers – implies consumers will only purchase from the lowest-cost supplier.
- Exit and entry are costless.
- Firms maximize profits subject to given cost conditions.
- Paradoxically: there is no competition in perfect competition.
What are the outcomes of a perfectly competitive industry? (4)
Why else is ( P = MC ) significant?
What are the outcomes of a perfectly competitive industry?
- ( P = MC ) ensures allocative efficiency: the price consumers pay equals the marginal cost of production.
- Maximizes social welfare, achieving a ‘first-best’ outcome.
- A fundamental requirement for Pareto efficiency.
- Only perfectly competitive industries automatically generate this result.
- Firms earn only ‘normal profits’; there is no economic rent.
Why else is ( P = MC ) significant?
- Relates to the Lerner index.
Rent is a surplus payment; Transfer Earning = Min payment to keep you in a particular employment
Lerner Index
What does the term on the lhs represent?
What does the term on the rhs represent?
What partly determines ŋ?
What is the interpretation of the Lerner index?
What is the range of the Lerner index?
What is the Lerner index in a perfectly competitive industry?
What is the Lerner index in a pure monopoly?
What are the formulas?
What does the term on the lhs represent?
- The term on the lhs is the price-cost markup.
What does the term on the rhs represent?
- The term on the rhs is the inverse of price elasticity of demand.
What partly determines ŋ?
- Slope only partly determines ŋ.
What is the interpretation of the Lerner index?
- Price cost mark-up (determined by industry structure) is a function of price elasticity of demand.
What is the range of the Lerner index?
- Lerner index ranges from 0 to 1.
What is the Lerner index in a perfectly competitive industry?
- In a perfectly competitive industry, \(L = 0\). because P=MC so it will equal 0
What is the Lerner index in a pure monopoly?
- In a pure monopoly, \(L = 1\).
Structure-Conduct-Performance paradigm: Simple model
How concentrated is the industry? (4 factors)? (Structure)
In the ‘simple’ model, what is the goal of conduct?
What is the standard measure of performance?
What other elements of performance might be considered? (2)
(1)
How concentrated is the industry?
- Minimum efficient scale (mes)
- Product differentiation
- Capital intensity of operations
- Advertising intensity
In the ‘simple’ model, what is the goal of conduct?
- In the long run, profit maximisation to make shareholders happy
What is the standard measure of performance?
- P = MC (allocative efficiency)
What other elements of performance might be considered?
- Productive efficiency (lowest possible costs of production)
- Research and Development (R & D)
Uni-directional causality; Structure determines the conduct and that determines the performance
Simple Examples of SCP
n = number of firms
Q = total output of all firms
QE= Average cost function is at its minimum
What is uni-directional causality in the SCP model?
How does the ‘simple’ model guide policy makers on industry competitiveness? (2)
Why do alternative specifications of SCP require trade-offs? (2)
How do monotonically decreasing average costs affect firm size? (2)
What is the trade-off between allocative and productive efficiency?
How does government intervention in pricing face challenges? (2)
How does reverse causality apply in SCP?
What is the relationship between structure, conduct, and performance in SCP?
How do different assumptions about conduct affect SCP?
What is another possible relationship between structure, conduct, and performance?
Why does the ‘simple’ SCP model only work with unidirectional causation?
What is uni-directional causality in the SCP model?
- The SCP model assumes causality flows in one direction.
How does the ‘simple’ model guide policy makers on industry competitiveness?
- Competitive industries are considered beneficial for social welfare.
- Concentrated industries are considered detrimental for social welfare.
Why do alternative specifications of SCP require trade-offs?
- Different SCP specifications lead to unclear guidance.
- Trade-offs and acceptance of second-best outcomes may be necessary.
How do monotonically decreasing average costs affect firm size?
- Larger firms benefit from decreasing average costs.
- This leads to natural monopolies due to absolute cost advantage.
What is the trade-off between allocative and productive efficiency?
- There is a balance between allocative efficiency and productive efficiency.
How does government intervention in pricing face challenges?
- Government intervention in pricing is considered. eg. cap on ROCE
- Asymmetric information (one party knows more than the other) complicates intervention.
How does reverse causality apply in SCP?
- Reverse causality can be considered in the SCP model.
What is the relationship between structure, conduct, and performance in SCP?
- Structure influences Conduct, which influences Performance.
How do different assumptions about conduct affect SCP?
- Different assumptions can be made about conduct.
What is another possible relationship between structure, conduct, and performance?
- Conduct influences Structure, which influences Performance.
Why does the ‘simple’ SCP model only work with unidirectional causation?
- The simple SCP model is valid only with unidirectional causation.
Picture
The metrics of structure (picture)
Use Concentration Ratio and HHI
Industry A is the most concentrated because the 5 biggest firms account for 100% of the market, and all firms have equal shares;
Industries, B, C, and D, each have 10 firms, but in B, the biggest firm is 10x the size of the smallest (0.5 v. 0.05);
In rank order, using the CR5, metric, the 4 industries can be ranked as: A, C (80%), B (75%), and D (50%).
In terms of competitive strategy, industries A, and D, are likely to be the most competitive (all firms have equal market shares), whereas industry B, is likely to be the least competitive (elements of dominant firm price leadership);
Industry C is more difficult to assess …
Using HHI,
the rank order is:
B (0.28), A (0.2), C (0.13), and D (0.1);
Why?
- A and D make sense: all firms in A have the same market share, as do all firms in D, therefore 1/N yields 0.2, and 0.1.
- Clearly A is more concentrated than D;
But why is B the most concentrated?
- HHI increases as the market share of firms become more unequal …
- Recall, the biggest firm in B was 10x the size of the smallest;
However, one of the disadvantages of the HHI is that it requires firm level data for all firms – very difficult/impossible to obtain.
HHI is more realistic and uses all firms’ data
