Market structures, efficiency and contestability

Question 1

What is meant by a 3-firm concentration ratio?

Answer 1

This measures the total market share of the top 3 firms in a market (not including ‘others’).

Question 2

What does it mean if a market has a ‘high’ concentration ratio?

Answer 2

It means that market power is concentrated amongst a few large firms, so the market is therefore less competitive.

Question 3

Give three examples of markets with high concentration ratios

Answer 3

The telecoms, banking and electricity markets e.g. Monopoly, Oligopoly and Duopoly markets have high market concentration.

Question 4

How do you calculate a concentration ratio (illustrate with a fictional example)?

Answer 4

If Tesco has 25% market share, Sainsbury’s have 20% market share and Morrisons have 15% market share then the 3-firm concentration ratio is 60%.

Question 5

What is meant by product differentiation?

Answer 5

When a firm makes its product design, features, or brand perception slightly different from its rivals.

Question 6

In what way is a Pizza Hut Pizza differentiated from a Pizza Express pizza?

Answer 6

Pizza express has a premium product, using thinner dough, more fresh ingredients, and more authentic Italian flavours. Its brand is aimed at a more affluent and older customer base compared to Pizza Hut.

Question 7

In what way is a Nokia phone differentiated from an i-phone?

Answer 7

I-phone has a ‘dimple’ which no other phone can copy. They also use a sleeker design and aim at a more premium customer. They differentiate using design, features and branding to make their products distinctive.

Question 8

Define Oligopoly

Answer 8

An Oligopoly is a market structure with a few large firms dominating the market.

Question 9

Give 4 examples of markets which are Oligopolistic and name the main companies

Answer 9

Banks: Lloyds, Barclays, Natwest and HSBC
Airlines: British Airways, Virgin, Quantas and American Airlines
Supermarkets: Tesco, Sainsbury’s, Morrisons, Waitrose
Mobile phone handsets: Apple, Sony, Nokia, Samsung

Question 10

What would you expect the concentration ratio to be like in an Oligopolistic market?

Answer 10

High.

Question 11

What characteristics would you associate with an Oligopolistic market?

Answer 11

Interdependence, high concentration ratio, few firms, high barriers to entry, differentiated products.

Question 12

What kinds of behaviour might you observe in an Oligopolistic market?

Answer 12

Non-price competition and collusion.

Question 13

What is meant by non-price competition, and name three ways a firm can engage in non- price competition?

Answer 13

Competing but avoiding direct price comparisons, for example, by comparing quality of product/service, by colluding, by merging with other companies, by advertising, by investing in new product development (R&D).

Question 14

What is meant by a cartel?

Answer 14

When more than one firm get together and behave/take actions as if they were one firm.

Question 15

Give an example of a cartel?

Answer 15

OPEC (Oil and Petroleum Exporting Countries).

Question 16

What is meant by price leadership?

Answer 16

When one firm is dominant in a market and when it changes price, all other competitors follow them regardless of whether it is a price rise or a price fall.

Question 17

Give an example of price leadership?

Answer 17

British Gas in the UK energy sector – when they raise price others tend to follow suit.

Question 18

What is meant by collusion?

Answer 18

When firms share information and agree not to compete.

Question 19

Name 2 different ways firms can collude

Answer 19

Price collusion or output collusion e.g. all agree to keep prices high, or agree to carve up the market for a product by agreeing who gets which customers.

Question 20

Give 2 examples of firms found guilty of collusion

Answer 20

Virgin and BA colluded on the fuel surcharge on flights, and the big supermarkets colluded on the price of cheese and other dairy products.

Question 21

Why is collusion against the public interest?

Answer 21

Because firms are explicitly agreeing not to compete with each other which can mean a higher price for consumers, or lower quality products/services and less choice.

Question 22

What factors increase the likelihood of collusion in an industry?

Answer 22

• The fewer the firms in the industry, the easier it is to come to an agreement
• The more mature the industry, the more likely the employees at different firms will know
each other and collude

Question 23

What is meant by a price war?

Answer 23

When one company drops price, and others follow suit, causing the first firm to drop price again and the process continues until either all companies give up, thus returning to the original price, or one/many companies surrender. A price war is generally damaging to all firms and they usually seek to avoid it.

Question 24

What does interdependence mean?

Answer 24

When a firm must consider the likely reaction of other firms when it makes decisions. Or in other words the actions of one firm in a market affect all the other firms in the market.

Question 25

How does interdependence create uncertainty in Oligopolistic markets?

Answer 25

Because it means that firms are unsure about the outcome of actions that they take, as they cannot be sure what their competitors reactions will be. This makes firms seek low risk strategies such as competing using non-price methods.

Question 26

What are the assumptions behind the kinked demand curve?

Answer 26

Assumes interdependence, and that when a firm raises price, others do NOT follow suit, and that when a firm drops price, others DO follow suit.

Question 27

Use the kinked demand curve diagram to explain why prices tend to be stable in an Oligopolistic market

Answer 27

If one firms increases price, then competitors will not follow suit, so the firm will lose market share and revenue (demand is elastic for a price rise), and that if one firm reduces price, then competitors will follow suit, so the firm will not gain market share and will lose revenue (demand is inelastic for a price fall). This means that the best option for the firm is to keep prices stable.

Question 28

What is game theory?

Answer 28

Game theory is a mathematic model that looks at the payoffs for firms in an Oligopoly market structure based on the decisions they make and how the other firm responds.

Question 29

According to game theory, how might co-operation and collusion improve the outcome for firms of each of the above firms?

Answer 29

If firms collude then they can formally agree to maintain the bottom left corner so that the best option can be maintained.

Question 30

With reference to game theory, explain why collusive agreements often break down

Answer 30

There is always an incentive to make short run profits by undercutting or breaking the agreement, particularly if the firm undercutting also acts as a whistle blower to the competition authorities. If they act as a whistle blower, they can often avoid a fine, so they can access the high payoff in the short run without financial penalty. However, this still does not solve the issue that when the collusion breaks down, both firms end up in the top left quadrant, and both are worse off.

Question 31

What is meant by productive efficiency?

Answer 31

A firm is productively efficient when they produce at lowest Average Total Cost = minATC.

Question 32

What is meant by allocative efficiency?

Answer 32

Allocative efficiency is when a firm produces where the price = marginal cost, P=MC.

Question 33

What is meant by dynamic efficiency?

Answer 33

Dynamic efficiency is when there is an increase in efficiency over time caused by innovation and Research and Development.

Question 34

Name three factors that would influence dynamic efficiency

Answer 34

A firm can only be dynamically efficient if they are able to make super-normal profits in the long- run and do one of the below with those super-normal profits: • Investment in research and development into capital improvement – this might improve the productivity of capital and hence reduce average total costs over time e.g. mechanisation of car production • Investment into improving production processes – this might also improve productivity as if there is a better way to complete a task, then this will reduce average total costs over time • Investment into new products and services – dynamic efficiency is often associated with improving productive efficiency, but investment into new and better products can improve allocative efficiency as the welfare generated by the products improves over time e.g. a candle vs a light bulb improves welfare whilst at the same time the price of the product as a proportion of income is falling

Question 35

Compare efficiency between perfectly competitive firms, and those in concentrated markets

Answer 35

According to the traditional theory of the firm, the extent of inefficiency depends on 2 factors: The number of existing competitors in the market (number of firms) and the barriers to entry controlling the threat of potential competition (this contrasts with contestable market theory that claims that it is only the potential competition that matters, not the number of existing firms). The extent of these 2 factors increases as we tend to monopolies – therefore the level of inefficiency in a Monopolistically competitive market will be less than that in a monopolistic market.

Question 36

What is meant by x-inefficiency?

Answer 36

Also known as ‘organisational slack’, a firm is x-inefficient if it is not producing on its lowest ATC curve. In other words at its chosen level of output, the unit costs of production are higher than they need to be to produce the same level of output. There are unnecessary costs in the business that could be removed without impacting on output e.g. biscuits in meeting if these do not increase productivity.

Question 37

What are the conditions that make it more likely for x-inefficiency to exist?

Answer 37

If there are high barriers to entry, then the firm is protected from the threat of competition and therefore this makes it more likely for x-inefficiency to exist. The higher the barriers to entry, the more likely it is that x-inefficiency will exist. The number of existing firms is also important as if there are many firms, then an x-inefficient firm is likely to be beaten on price by another firm, thus forcing them to reduce their costs in order to compete.