Micro 19 - Perfect competition and Monopolistic competition

Question 1

What are barriers to entry?

Answer 1

• Barriers to entry are factors that prevent or make it difficult for new firms to enter a market
• The existence of barriers to entry make the market less contestable and less competitive, but can however mean opportunities for greater profits for incumbent firms

Question 2

What are incumbent firms?

Answer 2

Incumbent firms are firms already in the market

Question 3

The greater the barriers to entry…

Answer 3

the less competitive the market will be

Question 4

What are the different types of barriers to entry?

Answer 4

• Set up costs
• Economies of scale
• Sunk costs
• Regulatory / legal barriers
• Brand loyalty through advertising
• Exclusive contracts, patents and licenses
• Predatory or limit pricing

Question 5

What are sunk costs as a barrier to entry?

Answer 5

Sunk costs are those that cannot be recovered when a firm leaves a market and include training and advertising costs and other fixed costs

Question 6

What is predatory / limit pricing as a barrier to entry?

Answer 6

The incumbent firm sets a low price so new entrants cannot make a profit at that price. This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make.

Question 7

Why do barriers to entry matter?

Answer 7

• They affect how many firms will operate in an industry
• They affect how vulnerable incumbent firms are to new entrants
• They influence the power held by suppliers and customers

Question 8

Define perfect competition

Answer 8

Perfect competition is a market structure where there are many buyers and sellers, where there is freedom of entry and exit to the market, where there is perfect knowledge and where all firms produce a homogenous product

Question 9

What are the characteristics of a market where there is perfect competition?

Answer 9

1- There are many buyers and sellers
2- No barriers to entry and exit of firms in the long run - the market is open to competition from new entrants. This affects the long run profits made by each firm in the industry meaning supernormal profits can only be made in the short term with firms making only normal profits in the long term
3- Identical output produced by each firm - homogenous products that are perfect substitutes for each other (no branding)
4- Perfect knowledge between producers - each firm has access to the same information including the latest technology and information on who makes supernormal profits
5- Perfect knowledge of prices among producers and consumers - if one firm charges a higher price than the market price the demand for its product will be zero as there are lots of substitutes
6- Due to the above conditions, each firm is a price taker - a firm which has no control over the market price and has to accept the market price if it wants to sell its products

Question 10

In a perfect competition market why can a business not sell below the market price?

Answer 10

They would make a loss as they are already as efficient as possible

Question 11

In a perfectly competitive market what is the PED for products from an individual firm?

Answer 11

Perfectly price elastic

Question 12

What affect does firms being price takers in perfectly competitive markets have on the demand curve and MR curve?

Answer 12

• The demand curve is perfectly elastic (horizontal demand curve)
• The MR curve and AR curve are the same curve (one curve representing both) and is also a horizontal line

Question 13

What price level will firms in a perfectly competitive market operate at?

Answer 13

Each firm profit maximise and so will operate at MR=MC

Question 14

Draw a supply and demand diagram for perfectly competitive industry

Answer 14

See page 8 in pack 19

Question 15

Draw a supply and demand diagram for an individual firm an a perfectly competitive market?

Answer 15

See page 8 in pack 19

Question 16

Explain briefly how the market price is determined and the types of profit that are made in a perfectly competitive market

Answer 16

• In a perfectly competitive market the industry/market determines the market price by the forces of supply and demand
• The individual firms sells its output at this price as firms are price takers facing perfectly elastic demand from customers due to the many substitutes available
• The firm profit maximises operating where MR=MC
• The firm makes normal profits with average cost being equal to average revenue

Question 17

Which of the three types of efficiency do firms in a perfectly competitive market meet and don’t meet?

Answer 17

• They are allocatively efficient as P=MC
• They are productively efficient as they are operating at the lowest AC
• They are not dynamically efficient as they don’t have supernormal profits to invest back into the business

Question 18

Draw a cost and revenue diagram showing the long run equilibrium position of a firm facing short-term losses

Answer 18

See page 10 in pack 19

Question 19

Draw a supply and demand diagram showing the long run equilibrium position of a firm facing short-term losses

Answer 19

See page 10 in pack 19

Question 20

Explain the supply and demand diagram showing the long run equilibrium position of a firm facing short-term losses

Answer 20

• The firm makes a loss at P1 Q1
• In the long run all factors of production are variable and so firms can leave the industry as there are not barriers to exit
• Supply shifts left and the market price increases to P2 (rationing effect of price mechanism)
• Perfect competition firms are price takers so price rises from P1 to P2
• Normal profits are made at P2 Q2 so no more firms will leave the market

Question 21

Do perfectly competitive markets exist?

Answer 21

In reality they are unlikely to exist, however it is useful to use the model of perfect competition as a benchmark so that other market structures can be compared in terms of price, output, profits and efficiency

Question 22

Define monopolistic competition

Answer 22

Monopolistic competition is a market structure with many firms producing a slightly differentiated product and where there are few barriers to entry and exit

Question 23

Why is a monopolistic competition market structure called monopolistic competition?

Answer 23

Firms aim to create their own monopolies within the overall market. There is a small degree of monopoly power each firm possesses as a result of a branded product

Question 24

What are the characteristics of a monopolistic competition market?

Answer 24

• A large number of firms are in the market but none are relatively large in terms of the overall market size
• Low barriers to entry making it easy for firms to enter this market. Barriers to exit are also low as firms can generally recoup their capital spending
• Firms generally aim to maximise profits
• Products are non-homogenous - there is product differentiation
• Each firm is a price maker and therefore has a downward sloping demand (AR) curve

Question 25

Define product differentiation

Answer 25

Product differentiation occurs either through real differences in products or perceived differences for similar products

Question 26

What is a price maker

Answer 26

• A price maker is a firm that has the power to be able to set its own prices for its products in a market
• The extent to which they can make their own prices will depend upon price elasticity for their products and how differentiated they are

Question 27

In monopolistic competition when are supernormal profits possible and not possible?

Answer 27

In monopolistic competition, supernormal profits are possible in the short term but not in the long term

Question 28

Draw a diagram to show how supernormal profits are possible in the short term in a monopolistic competition diagram and explain it

Answer 28

See page 14 in pack 19
- Firms produce at MR=MC to profit maximise
- Supernormal profits are made as AR is above AC
- The firm is neither productively or allocatively efficient

Question 29

Draw a diagram to show how supernormal profits are not possible in the long term in a monopolistic competition diagram and explain it

Answer 29

See page 14 in pack 19
- Due to low barriers to entry supernormal profits attract new firms
- New firms take away some demand from existing firms
- The demand curve for each firm shifts to the left and becomes more price elastic as there are now more subsitutes
- Some firms may leave the industry if they are facing losses
- Normal profits are now made (AR=AC)

Question 30

Which of the three types of efficiency are met by firms in a monopolistic competition market structure?

Answer 30

• Not productively efficient as the firm is not operating at the bottom of the AC curve
• Not allocatively efficient as the price charged is above marginal cost
• Not dynamically efficient due to no supernormal profit being make long term to fund investment programmes