Market structures

Question 1

Collusion

Answer 1

Collective agreement between firms that restricts competition

Question 2

Oligopoly

Answer 2

Market structure where a few large firms dominate an industry

Question 3

How do collusive oligopolies work?

Answer 3

Firms in an oligopoly market collude to set the same price for their products as their competitors, they act as a monopoly as there are no competition between these firms

Question 4

Draw diagram of oligopoly making SNP and describe what happens to these SNP

Answer 4

Same diagram as monopoly…
These supernormal profits made are divided up between oligopolistic firms

Question 5

What are the characteristics of an oligopoly?

Answer 5

Large firms
Small number of firms
High barriers to entry
Collusion
Profit maximisers
Price rigidity
Degree of independence
Some oligopolies compete by price and some compete by ‘non-price competition’ by advertising (non-collusive)
Some produce homogenous goods (non-collusive) and some produce differentiated goods

Question 6

What are the characteristics of a collusive oligopoly

Answer 6

Small number of firms
Firms with similar costs of production
Consumers loyalty and consumer inertia
High barriers to entry/exit

Question 7

What are the characteristics of a non-collusive oligopoly

Answer 7

Large number of firms
Produces homogenous goods
One firm may have higher costs of production than the others
Lower barriers to entry/ exit
Degree of interdependence

Question 8

Name the two types of collusive oligopolies

Answer 8

Cartel (Formal agreement)
Tacit (informal agreement)

Question 9

How does a cartel work

Answer 9

Firms openly agree on the price they will set and and the quantity they will produce, this is illegal and against public interest. This often results in a higher price charged and a lower quantity produced

Question 10

Draw a diagram for a cartel

Answer 10

Question 11

Explain the cartel diagram

Answer 11

Collusive oligopolies under formal cartel agreements agree to raise prices from P1 to P2, forcing consumers to pay a higher price, leading to loss of consumers surplus. The restriction on the quantity produced from Q1 to Q2 causes a misallocation of resources, leading to a welfare loss triangle. It also lead to allocative inefficient as it is moving away from point MC=AR. Collusive agreements would be against the best interests of consumers thus cartels are banned by the government. So the government may impose a range of competition policies to prevent anti-competitive behaviour

Question 12

Exception of cartel

Answer 12

OPEC

Question 13

How does a tacit work?

Answer 13

Firms in oligopolistic competition charge the same price as their competitions but without a formal agreement, by looking to see what prices their competitors charge in the market, then they decide to set the same price. They may even look at what price the dominant firm is charging. This could be done without any communication between firms.

Question 14

Cartel

Answer 14

A formal agreement on the price firms in oligopolistic competition will charge

Question 15

Tacit

Answer 15

When firms charge the same price as their competitors without any communication or any formal agreements

Question 16

Two theories that support the idea of non-price competition

Answer 16

Game theory and kinked demand curve

Question 17

Draw the kinked demand curve and explain it

Answer 17

The firm knows one point on its demand curve. At price P1, the quantity demanded is at Q1 so the total revenue would be P1 x Q1. If this firm chooses to increase its price from P1 to P2, there would be a larger reduction in quantity demand from Q1 to Q2 and lose many customers. These customers would buy from its rival firms instead do the same. This means that rival firms will have a lower price than this firm and this firm will lose its customers. These customers will buy from its rival competitors instead. This means that the demand curve is elastic. The new revenue becomes P2 x Q2 which is less than the original revenue. Therefore when firms in oligopolies increase its price, its revenue will fall so they will not increase their prices. Prices are rigid. Similarly, if a firm decreases its price to P3, rival firms will follow suit and start a price war. So when firm reduces its price there would be little increase in demand because rival firms would have done so too, the demand curve is inelastic. Revenue falls to P3 x Q3. Therefore, if firms in oligopoly reduce their prices, their revenue will fall so they won’t reduce their prices. Prices are rigid

Question 18

Limitations on the kinked demand curve

Answer 18

There is no explanation of where the original price at P1 is derived from
It assumes all rival firms will act in the exact same way to the change in the firm’s prices but they don’t.
It only looks at the effects of price-competition and not effects on non-price competition such as advertising

Question 19

Game theory

Answer 19

Game theory is based on the idea of the ‘Prisoner’s Dilemma’ scenario. It is a paradox suggesting that two people acting in their own self-interests do not produce the most optimal outcome

Question 20

Explain the theory behind game theory

Answer 20

Game theory suggests that there are two firms in the market both charging the same price and making same profit . If one firm decides to lower its price, this firm would make more profits than the other because this firm would take greater market share and attract more customers and vice versa. However, if the other firm follows suit both firms will lose out and see a reduction in their profits , the Nash equilibrium is reached. Both firms are disadvantaged by their decisions. Therefore firms in oligopolies do not compete on price

Question 21

What characteristic of an oligopoly do kinked demand curve and game theory suggest

Answer 21

Degree of interdependence

Question 22

Examples of oligopolies

Answer 22

Adidas and pumas, tescos and Sainsbury’s and Coca-Cola and Pepsi

Question 23

How do oligopolies compete by ‘non-price competition’

Answer 23

Advertising, brand image, reputation, packaging, sponsorship deals

Question 24

When do oligopolies compete on price?

Answer 24

Limit pricing (contestable markets - where firms temporarily lower their prices and increase their quantity due to the threat of new firms entering the market), special offer pricing (Black Friday deals), predatory pricing (where firms lower prices below costs of production and gain market share to drive out competitors)

Question 25

Efficiency of oligopolies

Answer 25

Collusive: because they act like a monopoly, they are more likely to make larger supernormal profits which can be used to invest, invent and innovate in improved production techniques and product development for their consumers, in which consumers will benefit in the long-run, achieving dynamic efficiency. However, they are neither productive or allocative efficient due to their high prices and low quantity produced and there is no incentive for them to cut costs, leading to a reduction in consumers surplus and a misallocation of resources. They are also not very X-efficient due to the large amounts of waste produced. Non-collusive: They are more likely to be more productively or allocatively efficient as they have greater incentives to cut costs of production and they do not restrict their output, producing the right quantity of goods and services, where S=D. Therefore, overall more statically efficient than collusive oligopolies. Less waste is also created so reducing X-inefficiency. However, they are not as dynamically efficient as collusive oligopolies due to lower supernormal profits made, they may not likely to be be putting in large amounts of investments into production techniques and their products.

Question 26

Other disadvantages of non-collusive and collusive oligopolies (not relating to efficiency)

Answer 26

Economies of scale. Non-collusive oligopolies may not benefit from economies of scale as they are likely produce to a lower output, which means that they may experience higher average total costs than collusive oligopolies. However, collusive oligopolies may also end up in diseconomies of scale where collusive oligopoly becomes too large therefore producing at extremely high costs. If the firm cannot cover their high average variable costs with their average revenue, then the firm should shut-down.

Question 27

Price discrimination

Answer 27

When a firm charges different prices to different customers for an identical product with no differences in costs of production

Question 28

Conditions for price discrimination

Answer 28

Firms must have monopoly power and price-making ability Must be separate markets and different groups of consumers with different PEDs No market seepage (where a consumer who bought it at a lower price in a elastic market cannot resell it for a higher price in an inelastic market) Cost of selling to different markets can’t be too high

Question 29

Examples of price discrimination

Answer 29

Train tickets Plane tickets Loyalty cards Hotel bookings

Question 30

First degree of discrimination

Answer 30

Consumers pay the same exact price they are ready and willing to pay. There is no consumers surplus

Question 31

Second degree price discrimination

Answer 31

Occurs in industries where there is a fixed capacity. Consumers may be charged lower prices than the original price last minute if there is spare capacity. An example would be hotels, hotels tend to charge lower prices to fill empty rooms as fixed costs still have to be paid by firms.

Question 32

Diagram for second degree price discrimination and explanation

Answer 32

Originally, the firm charges price of P1 where MC=MR because firm is a profit maximiser, in which only uses up Q1 of firm’s capacity. Later in time, firm may choose to lower its price to the competitive price at P2 to fill in spare capacity. The marginal cost curve is perfectly elastic up until point of fixed capacity because the marginal cost is constant until beyond the fixed capacity. As a result of a fall in price, there is a gain of consumer surplus and an increase in allocative efficiency.

Question 33

Third degree price discrimination

Answer 33

When consumers in different segments of the market are charged different prices for an identical product. These segments could be based on age, location, time and incomes.

Question 34

Diagram for third degree price discrimination and explanation

Answer 34

Taking train travel as an example, in markets which are more elastic prices charged will be lower than in markets that are more in elastic with the same constant marginal costs, prices charged where MC=MR for profit maximisation. In train travel, more elastic markets would be train tickets sold on the weekends (for leisure travelling) versus train tickets sold on weekdays at rush hours (for work) which is more inelastic. Given that consumers will still likely to travel at rush hours, regardless of the price in an inelastic market, so higher prices are charged.

Question 35

Creative destruction

Answer 35

Capitalism evolving and renewing itself over time through new technologies and innovations replacing older ones. E.g. old phone companies.

Question 36

Invention

Answer 36

Creation of a new idea without it becoming a commercial reality.

Question 37

Innovation

Answer 37

Transforming an invention into a commercial reality or a marketable product.

Question 38

Types of innovation

Answer 38

Small scale Large scale Sustaining Disruptive

Question 39

Small scale innovation

Answer 39

Improvement in production technique

Question 40

Large scale innovation

Answer 40

Creation of a new product

Question 41

Sustaining innovation

Answer 41

Similar/ incremental product developments such as medicine

Question 42

Disruptive innovation

Answer 42

New products that take customers away from existing products

Question 43

Why can disruptive innovation can be destructive?

Answer 43

New ideas replace old existing ideas, destroying old markets This can lead to job losses in the industry and cause unemployment

Question 44

Diagram for creative destruction

Answer 44

Over time, production techniques change with technology in which capital may start to replace labour, for greater productivity. The diagram suggest an increase in technology will cause a reduction in average total costs as firms can produce greater outputs with fewer inputs, so LRATC1 shifts to LRATC2 downwards. This shows minimum efficient scale (MES) takes place at a greater quantity at a lower price, increasing economies of scale.

Question 45

Outcomes of technological advancements

Answer 45

Lower barriers to entries Firms no longer require physical premises to run a business, online shops are now very common to avoid fixed costs, such as rent and electricity, sunk costs, start-up costs and wages. However, it can be argued that because firms’ costs are lower they can afford artificial barriers to entry such as patents and copyrights so barriers to entries are higher. Knowledge also increases As consumers can easily find out price of products and producers can also take advantage of technology to look what prices its competitors are charging and charge the same price.

Question 46

Contestable markets

Answer 46

A market where there is a threat of competition, but not actual competition.

Question 47

Advantages of price discrimination on producers (the firm itself)

Answer 47

Advantages: - Greater dynamic efficiency Price discrimination could lead to greater supernormal profits which can be used to invest, invent and innovate new production techniques to increase productivity and used for product development, in which can attract new customers. This will bring in even more profit for the firm as well as increasing market share. Economies of scale With second degree and third degree price discrimination, it could lead to firm producing a higher output and greater utilisation of resources, making use of its spare capacity. ‘Insert diagram of internal economies of scale’. As a result, average costs falls from C1 to C2 as internal economies of scale is achieved. Cross-subsidisation In second degree and third degree price discrimination, firms can use the supernormal profits made from charging some consumers higher prices to subsidise the lower profits made from charging some consumers lower prices. This can act as a safety net by allowing. Also-making firm to continue operating. Transfers consumers surplus to additional revenue for firms

Question 48

Advantages and disadvantages of price discrimination on consumers

Answer 48

Advantages: Increase in consumers surplus Some consumers may feel that they re being charged a lower price compared to the price they are willing to pay for or compared to other consumers in an inelastic market. EVALUATE: although the benefit brought about is very minimal as possibly only a small proportion of consumers are benefited Cross-subsidisation It involves the idea of fairness and equity, where profit made from consumers who are charged a higher price are subsidised and redistributed to consumers with lower incomes who are only able to pay for a lower price. This allows consumers with lower incomes to still be able to access the good. Therefore, everyone benefits from the good with fairness. Economies of scale With second degree and third degree price discrimination, firms may be producing at a higher output causing its average costs to fall. Often, firms may pass down these lower costs to consumers in the form of lower prices, so increasing consumers surplus. Disadvantages: Allocative inefficiency Often prices charged are greater than the marginal costs, exploiting consumers and also lead to allocative inefficiency as firms do not operate where MC=AR. This leads to a reduction in consumers surplus and a welfare loss as there is a misallocation of resources.

Question 49

Conditions of a contestable market

Answer 49

Lower barriers to entry Potential entrants to the market Good information Hit and run (where established firms are exposed to firms which enter the market temporarily to take a portion of the total revenue with no sunk costs and then leave the market quickly before existing firms can react and lower their prices.)

Question 50

Role of technology in contestable markets

Answer 50

Lowers barriers to entries No physical premise needed to run a business which means businesses can avoid fixed costs such as rent and additional electricity as online shops can be easily established. Easier communication There will be much easier communication though the internet to give much better information about firms’ products as well as researching for suppliers

Question 51

Contestable market diagram

Answer 51

Firms in perfect competition are making a supernormal profit at price P1 and producing at Q1. Firms feel there is a a threat of competition as new firms want to join the market as there are now lower barriers to entry from improvements in technology. As a result, firm temporarily lower their price to the entry-limit pricing to P2 to where AR = ATC the break even point, now only making a normal profit as well as increasing output to Q2. This should make entering the market less attractive as supernormal profits are no longer made, so new firms no longer want to enter the market so threat is gone. However, if these firms still choose to enter the market, there is actual competition.

Question 52

Compromise theory in contestable markets

Answer 52

However, in reality firm may choose to lower their prices all the way down to the entry-limit pricing as this is the extreme. But cutting the price towards P2 will lower profits so this should disincentivise new firms from entering

Question 53

Advantages of contestable markets

Answer 53

Increase in allocative efficiency As prices fall where AR = ATC to break-even point, the firm now produces at a greater quantity at a lower price nearer to the point where MC = AR. This helps the firm to achieving closer to allocative efficiency and eliminate any misallocation of resources. The lower prices in short term will also increase consumers surplus. Increase in productive efficiency When producing at greater output, this allows greater internal economies of scale to occur, causing average costs to fall, increasing productive efficiency. Increase in X-efficiency Contestable markets incentivises firms to reduce their costs in order to prevent losing market share. OVERALL INCREASES STATIC EFFICIENCY Help prevent anti-competitive practices in short-term The threat of competition causes firms to temporarily lower their prices to restrict making excessive profits and offering better quality products, so disincentivises new firms entering the market. The threat can temporarily stop the exploitation of consumers and forces firms to act more competitive. EVALUATION: However, this may not have much of an impact as this threat is only likely to be long term which means firms will increase their prices and restrict their output again once the threat is gone. Job creation It can be argued that an increase in output can increase the derived demand for labour to produce more output, leading to fall in unemployment

Question 54

Disadvantages of contestable markets

Answer 54

Decrease in dynamic efficiency As firms lower their prices and increase their output, firms are less likely to make supernormal profits as now they are making either near or making a normal profit. So it cannot be used to invest, invest and innovate new production techniques and develop products, in which consumers can benefit in the long-run. Job losses Can also be argued that when new firms join the market with better innovation and technology and replaces old existing monopolies, it can cause job losses and unemployment BUT possibly only in the short run as they will get picked up by the new firms?

Question 55

In conclusion the extent to which contestable markets have any impact on the market depends on…

Answer 55

Level of sunk costs Barriers to entries (natural? - start-up costs artificial? - patents) Number of entrant firms

Question 56

How to approach a CMA 25-marker

Answer 56

Define Competition Policy - part of the government, an industrial policy which aims to make markets more competitive Identify the problem, why is competition policy used? - monopoly is a firm that holds 25% or more market shares in the industry and has a lot of market power and able to set its own price, they are price makers. Draw monopoly diagram making supernormal profit Explain the diagram - profit maximisers, produce where MC = MR and have the ability to make a supernormal profit in the short run and long run due to very high barriers to entry, used to achieve dynamic efficiency. Not statically efficient and explain points of productive and allocative efficiency. Explain that firms with market power always produce at a much lower quantity and a higher price, leading to monopoly abuse where consumers are exploited so also causing market failure Solution - the government imposes competition policy to prevent anti-competitive practices and increase competition. In the UK, a type of competition poly called th monopoly policy can be imposed by the CMA, by monitoring the structure, conduct and performance of the market. Policies - regulators could impose a maximum price on rate of returns capital, a form of price setting regulation where the government determines a fair price charged by the monopoly, in which is determined by the size of the firm. Draw diagram monopoly decreasing its price to its competitive price and increasing output. As a result, price falls from P1 to P2 the competitive price and the quantity produced increases from Q1 to Q2, allowing allocative efficiency to be achieved where MC = AR as well as a gain of consumers surplus. However, rate of return regulation often provides little incentive for firms to cut costs and increase efficiency as there are lower barriers to entry and monopolies would not earn more if costs are reduced. Hence still causing productive inefficiency. Solution 2 - another way is privatising monopolies as the conservatives believe that monopoly abuse occurs in nationalised industries. Industries that are nationalised run in the interest of a feather-bedded workforce where they are protected against any form of market discipline, causing them to operate inefficiently. Whereas privatisation exposes the industry to the threat of takeover and the discipline of the capital market, allowing efficiency and commercial performance to be improved. Evaluation - However, privatisation cannot eliminate all problems of monopoly as it only merely changes the nature of the problem and the commercial exploitation of a monopoly position So deregulation would be accompanied with privatisation in order to increase competition in order to lower barriers to entry. Additionally some may argue state ownership rather than privatisation as monopolies are assumed to act solely from private ownership in pursuit of private profits. Conclusion - comeptition policy good and increase comeptition and reducing barriers to entry, but there is a loss of dynamic effiency, less economies of scale. CMA takes a long time to respond and is very opaque, so can.be ineffective . Can help achieve objectives but also cause other problems

Question 57

Maximum rate of returns on capital

Answer 57

a form of price setting regulation where the government determines a fair price charged by a monopoly, determined by the size of the firm. This allows allocative efficiency to be achieved but provides little incentive for firms to cut costs as monopoly cannot earn more with lower costs, meaning that there is still productive inefficiency.

Question 58

Privatisation

Answer 58

The conservatives believe monopoly abuse occurs in nationalised industries as industries that are nationalised often run in the interest of a feather-bedded workforce where they re protected against any form of market discipline