Perfect Competition, Imperfectly Competitive Markets and Monopoly

Question 1

different market structures

Answer 1

LOWER BARRIERS TO ENTRY, MORE CONTESTABLE
perfect competition
monopolistic competition

MORE MARKET POWER, LESS EFFICIENCY
oligopoly
monopoly

Question 2

Each market structure is characterised by:

Answer 2

The number of firms in the market.

The more firms there are, the more competitive the market is.

The degree of product differentiation.

The more differentiated the products, he less competitive the market. In a perfectly competitive market, products are homogenous. Products can be differentiated using price, branding and quality. This affects cross price elasticity of demand.

Ease of entry into the market.

This is the number and degree of the barriers to entry. Barriers to entry are designed to prevent new firms entering the
market profitably

Question 3

examples of high barriers to entry

Answer 3

Economies of scale.

 Brand loyalty, which makes demand more inelastic. It is hard for new
firms to gain consumer loyalty, when one firm’s brand name is already
strong.

 Controlling the important technologies in the market.

 Having a strong reputation.

 Backwards vertical integration, which controls supply, means firms
can control the price they pay their suppliers. This makes it hard for
new firms to compete on price, which is a barrier to entry.

 Barriers to entry can be structural, where they arise due to
differences in production costs, strategic, where firms use different
pricing policies, such as undercutting another firm’s price, or
statutory, where patents protect a franchise. An example of this is a
television broadcasting licence.

Question 4

Break even

Answer 4

Firms break even when TR = TC

Question 5

profit increases

Answer 5

when MR > MC. Profits decrease when MC > MR

Question 6

Some firms choose to profit maximise because:

Answer 6

o It provides greater wages and dividends for entrepreneurs

o Retained profits are a cheap source of finance, which saves paying high
interest rates on loans

o In the short run, the interests of the owners or shareholders are most
important, since they aim to maximise their gain from the company.

o Some firms might profit maximise in the long run since consumers do not like
rapid price changes in the short run, so this will provide a stable price and
output.

Question 7

characteristics of perfect competition

Answer 7

A perfectly competitive market has the following characteristics:
o Many buyers and sellers
o Sellers are price takers
o Free entry to and exit from the market
o Perfect knowledge
o Homogeneous goods
o Firms are short run profit maximisers
o Factors of production are perfectly mobile

Question 8

what are profits likely to be like in a competitive market

Answer 8

profits are likely to be lower than a market with only a few
large firms. This is because each firm in a competitive market has a very small market
share. Therefore, their market power is very small.

Question 9

what effect does new firms joining have

Answer 9

. The new firms will increase supply in the market, which lowers the
average price. This means that the existing firms’ profits will be competed away

Question 10

profit maximisation in the short run

Answer 10

firms can make supernormal profit

Question 11

profit maximisation in the long run

Answer 11

profits are competed away and only normal profit are made

Question 12

adv of perfectly competitive markets

Answer 12

In the long run, there is a lower price.
P =MC, so there is allocative
efficiency.

Since firms produce at the bottom of
the AC curve, there is productive
efficiency.

The supernormal profits produced in
the short run might increase dynamic
efficiency through investment.

Question 13

disadv of perfectly competitive markets

Answer 13

In the long run, dynamic efficiency
might be limited due to the lack of
supernormal profits.

Since firms are small, there are few or
no economies of scale.

The assumptions of the model rarely
apply in real life. In reality, branding,
product differentiation, adverts and
positive and negative externalities,
mean that competition is imperfect.

Question 14

characteristics

Answer 14

A monopolistically competitive market has imperfect competition. Firms are short
run profit maximisers.

Firms sell non-homogeneous products due to branding (there is product
differentiation). However, there are a lot of relatively close substitutes. This makes
the XED of the goods and services sold high.

The model is based on the assumption that there are a large number of buyers and
sellers, which are relatively small and act independently.
Each seller has the same
degree of market power as other sellers, but their market power is relatively weak.

Firms in a monopolistically competitive market compete using non-price
competition.

There are no barriers to entry to and exit from the market.

Since firms have a downward sloping demand curve, they can raise their price
without losing all of their customers. This is because firms have some degree of price
setting power.

Buyers and sellers in a monopolistically competitive market have imperfect
information.

Examples of monopolistic competition include hairdressers and regional plumbers.

Question 15

short run profit maximising ( monopolistic comp)

Answer 15

In the short run, firms profit maximise at the point MC = MR. The area P1C1A B
represents the supernormal profits that firms in a monopolistically competitive
market earn in the short run.

Question 16

long run profit maximising ( monopolistic comp)

Answer 16

, new firms enter the market since they are attracted by the profits
that existing firms are making. This makes the demand for the existing firms’
products more price elastic which shifts the AR curve (the demand curve) to the left

Question 17

disadvantages of monopolistically competitive
markets

Answer 17

Firms are not as efficient as those in a
perfectly competitive market. In a
monopolistically competitive market,
firms have x-inefficiency, since they
have little incentive to minimise their
costs.

In the long run, dynamic efficiency
might be limited due to the lack of
supernormal profits.

Question 18

advantages of monopolistically competitive
markets

Answer 18

Firms are allocatively inefficient in the
short and long run (P > MC)
In the long run, dynamic efficiency
might be limited due to the lack of
supernormal profits.

Since firms do not fully exploit their
factors, there is excess capacity in the
market. This makes firms productively
inefficient (also note: the firm does
not operate at the bottom of the AC
curve). This is in both the short run
and long run#

Consumers get a wide variety of
choice.

The model of monopolistic
competition is more realistic than
perfect competition.

The supernormal profits produced in
the short run might increase dynamic
efficiency through investment.

Question 19

Characteristics of an oligopoly

Answer 19

High barriers to entry and exit

High concentration ratio

Interdependence of firms

Product differentiation

Question 20

High barriers to entry and exit (oligopoly)

Answer 20

There are high barriers of entry to and exit from an oligopoly. High barriers to entry
make the market less competitive.

Question 21

High concentration ratio (oligopoly)

Answer 21

In an oligopoly, only a few firms supply the majority of the market. For example, in
the UK the supermarket industry is an oligopoly. The high concentration ratio makes
the market less competitive.

Question 22

Interdependence of firms (oligopoly)

Answer 22

Firms are interdependent in an oligopoly. This means that the actions of one firm
affect another firm’s behaviour.

Question 23

Product differentiation (oligopoly)

Answer 23

Firms differentiate their products from other firms using branding. The degree of
product differentiation can change how far the market is an oligopoly.

Question 24

Oligopoly as a market structure and a behaviour

Answer 24

Firms can either operate in a market which is oligopolistic, or several firms can
display oligopolistic behaviour.
Firms which display oligopolistic behaviour might be interdependent, have stable
prices, collude or have non-price competition.

Question 25

The difference between collusive and non-collusive oligopoly

Answer 25

Collusive behaviour occurs if firms agree to work together on something. For example, they might choose to set a price or fix the quantity of output they produce, which minimises the competitive pressure they face. Collusion leads to a lower consumer surplus, higher prices and greater profits for the firms colluding. It can allow oligopolists to act as a monopolist and maximise their joint profits. Firms in an oligopoly have a strong incentive to collude. By making agreements, they can maximise their own benefits and restrict their output, to cause the market price to increase. This deters new entrants and is anti-competitive. Collusion is more likely to happen where there are only a few firms, they face similar costs, there are high entry barriers, it is not easy to be caught and there is an ineffective competition policy. Moreover, there should be consumer inertia. All of these factors make the market stable. Non-collusive behaviour occurs when the firms are competing. This establishes a competitive oligopoly. This is more likely to occur where there are several firms, one firm has a significant cost advantage, products are homogeneous and the market is saturated. Firms grow by taking market share from rivals.

Question 26

overt collusion

Answer 26

Overt collusion is when a formal agreement is made between firms. It works best when there are only a few dominant firms, so one does not refuse. It is illegal in the EU, US and several other countries.

Question 27

tacit collusion

Answer 27

Tacit collusion occurs when there is no formal agreement, but collusion is implied. For example, in the UK supermarket industry, firms are competing in a price war. Price wars are harmful to supermarkets and their suppliers

Question 28

The difference between cooperation and collusion

Answer 28

Cooperation is allowed in the market, whilst collusion is not. Collusion is usually with poor intentions, whilst cooperation will be beneficial. Collusion generally refers to market variables, such as quantity produced, price per unit and marketing expenditure. Cooperation might refer to how a firm is organised and how production is manag

Question 29

The kinked demand curve model

Answer 29

The kinked demand curve illustrates the feature of price stability in an oligopoly. It assumes other firms have an asymmetric reaction to a price change by another firm. It is an illustration of interdependence between firms.

Question 30

cartel

Answer 30

a group of two or more firms which have agreed to control prices, limit output, or prevent the entrance of new firms into the market. A famous example of a cartel is OPEC, which fixed their output of oil. This was possible since they controlled over 70% of the supply of oil in the world. This reduces uncertainty for firms, which would otherwise exist without a cartel.

Question 31

Price leadership

Answer 31

occurs when one firm changes their prices, and other firms follow. This firm is usually the dominant firm in the market. Other firms are often forced into changing their prices too, otherwise they risk losing their market share This explains why there is price stability in an oligopoly; other firms risk losing market share if they do not follow the price change. The price leader is often the one judge to have the best knowledge of prevailing market conditions.

Question 32

Price wars:

Answer 32

A price war is a type of price competition, which involves firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match. Further price cuts by one firm will lead to more and more firms cutting their prices. An example of this is the UK supermarket industry (see notes above).

Question 33

Non-price competition

Answer 33

n aims to increase the loyalty to a brand, which makes demand for a good more price inelastic. For example, firms might improve the quality of their customer service, such as having more available delivery times. They might keep their shops open for longer, so consumers can visit when it is convenient.

Question 34

ways to increase non price competition

Answer 34

Special offers, such as buy one get one free, free gifts, or loyalty cards, might be used to attract consumers and increase demand. Advertising and marketing might be used to make their brand more known and influence consumer preferences. However, it is difficult to know what the effect of increased advertising spending will be. For some firms, it might be ineffective. This would make them incur large sunk costs, which are unrecoverable.

Question 35

Barriers to entry

Answer 35

Firms might try to drive competitors out of the industry in order to increase their own market share. Barriers to entry are designed to prevent new firms entering the market profitably. This increases producer surplus.

Question 36

dominant strategy

Answer 36

The two prisoners are not allowed to communicate, but they can consider what the other prisoner is likely to choose. This relates to the characteristic of uncertainty in an oligopoly the option which is best, regardless of what the other person chooses. This is for both prisoners to confess, since this gives the minimum number of years that they have to spend in prison

Question 37

The advantages of oligopoly

Answer 37

Oligopolies can earn significant supernormal profits, so they might invest more in research and development. This can yield positive externalities, and make the monopoly more dynamically efficient in the long run. There could be more invention and innovation as a result. Moreover, firms are more likely to innovate if they can protect their ideas. This is more likely to happen in a market where there are high barriers to entry. Higher profits could be a source of government revenue. Industry standards could improve. This is especially true in the pharmaceutical industry and for car safety technology. This is because firms can collaborate on technology and improve it. It saves on duplicate research and development. access to economies of scale

Question 38

disadvantage of oligopoly

Answer 38

The basic model of oligopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market. If firms collude, there is a loss of consumer welfare, since prices are raised and output is reduced. Collusion could reinforce the monopoly power of existing firms and makes it hard for new firms to enter. The absence of competition means efficiency falls. This increases the average cost of production

Question 39

Characteristics of monopoly:

Answer 39

o Profit maximisation. A monopolist earns supernormal profits in both the short run and the long run. o Sole seller in a market (a pure monopoly) o High barriers to entry o Price maker o Price discrimination

Question 40

what is a monoploy

Answer 40

when one firm dominates the market with more than 25% market share, the firm has monopoly power.

Question 41

what is pure monopoly

Answer 41

when a firm has 100% market share (THEORETICAL) not many examples of this

Question 42

Barriers to entry (Monopoly)

Answer 42

The higher the barriers to entry, the easier it is for firms to maintain monopoly power.

Question 43

Economies of scale (monopoly)

Answer 43

As firms grow larger, the average cost of production falls because of economies of scale. This means existing large firms have a cost advantage over new entrants to the market, which maintains their monopoly power. It deters new firms from entering the market, because they are not able to compete with existing firms

Question 44

limit pricing (monopoly)

Answer 44

This involves the existing firm setting the price of their good below the production costs of new entrants, to make sure new firms cannot enter profitably.

Question 45

Owning a resource (monopoly)

Answer 45

Early entrants to a market can establish their monopoly power by gaining control of a resource. For example, BT owns the network of cables so new firms would find it very difficult to enter the market.

Question 46

Sunk costs: (monopoly)

Answer 46

: If unrecoverable costs, such as advertising, are high in an industry, then new firms will be deterred from entering the market, because if they are unable to compete, they do not get the value of the costs back.

Question 47

Brand loyalty: (monopoly)

Answer 47

If consumers are very loyal to a brand, which can be increased with advertising, it is difficult for new firms to gain market share.

Question 48

Set-up costs: (monopoly)

Answer 48

If it is expensive to establish the firm, then new firms will be unlikely to enter the market.

Question 49

The number of competitors: (monopoly)

Answer 49

The fewer the number of firms, the lower the barriers to entry, and the harder it is to gain a large market share.

Question 50

Advertising (monopoly)

Answer 50

Advertising can increase consumer loyalty, making demand price inelastic, and creating a barrier to entry.

Question 51

The degree of product differentiation

Answer 51

The more the product can be differentiated, through quality, pricing and branding, the easier it is to gain market share. This is because the more unique the product seems, the fewer competitors the firm faces

Question 52

Profit maximising equilibrium: (monopoly)

Answer 52

A monopolist earns supernormal profits in both the short run and the long run. This is at the point MC = MR, so the monopolist produces an output of Q1 at a price of P1

Question 53

disadvantages of monopoly

Answer 53

The basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market Monopolies could exploit the consumer by charging them higher prices. This means the good is under-consumed, so consumer needs and wants are not fully met. This loss of allocative efficiency is a form of market failure Monopolies have no incentive to become more efficient, because they have few or no competitors, so production costs are high. There is a loss of consumer surplus and a gain of producer surplus. If a monopolist raises the market price above the competitive equilibrium level, output will fall from Q1 to Q2. This leads to gains in producer surplus. Consumers do not get as much choice in a monopoly as they do in a competitive market.

Question 54

Advantages of monopoly

Answer 54

Monopolies can earn significant supernormal profits, so they might invest more in research and development. This can yield positive externalities, and make the monopoly more dynamically efficient in the long run. There could be more invention and innovation as a result. Moreover, firms are more likely to innovate if they can protect their ideas. This is more likely to happen in a market where there are high barriers to entry, If there is a natural monopoly, it might be more efficient for only one firm to provide the good or service, since having duplicates of the same infrastructure might be wasteful. For example, it might be considered inefficient and wasteful to have two lots of water suppliers. Monopolies could generate export revenue. For example, Microsoft generates a lot of export revenue for America. Since monopolies are large, they can exploit economies of scale, so they have lower average costs of production. The long run average cost curve can be used to show this: