Different Market Structures

Question 1

Firm

Answer 1

Business organisation that buys and hires factors of production in order to produce goods and services that can be sold as a profit.

Question 2

Small and medium enterprise

Answer 2

Firms with fewer than 250 employees.

Question 3

Small firms

Answer 3

Firms with fewer than 50 employees.

Question 4

Industry

Answer 4

Sum of all the firms making the same product or in the same line of business.

Question 5

Multinational corporation (MNC)

Answer 5

A firm that operates in different countries.
> Example: Nestle (Switzerland) for food and confectionary

Question 6

Market structure

Answer 6

1. The way in which a market is organised in terms of the number of firms and the barriers to entry of new firms.
2. Describe how goods and services are supplied by firms in the industry.
3. Characteristics include numbers of firms and their size, the similarity of goods supplied, and barriers to entry.

Question 7

Barriers to entry

Answer 7

1. A range of obstacles that deter or prevent new firms from entering a market to compete with existing firms.
2. This gives firms a degree of market power.
   > Can make decisions without the risk of their market share or price being challenged from outside.
3. New firms will only enter if they think that the economic returns are greater than the cost of breaking down the barriers.

Question 8

Four types of barriers

Answer 8

1. Legal barriers
   > state-owned economic activities
   > patent
   > licence
2. Market barriers
   > advertising and brand names with a high degree of consumer loyalty
   > brand proliferation
   > collaboration
   > fall in demand resulting from recession
3. Cost barriers
   > access to capital
   > economies of scale
   > limiting pricing
4. Physical barriers
   > monopoly access to raw materials, components or retail outlets
   > vertically-integrated manufacturing businesses
   > rapid production innovation

Question 9

Barriers to exit

Answer 9

1. Any restriction that prevents a firm leaving a market.
2. Sunk cost
   > If a firm choses. to shut down, the firm will incur sunk costs which are costs that cannot be recovered.
   > Examples: advertising cost, research and development costs.

Question 10

Perfect competition

Answer 10

1. Many buyers and sellers have perfect knowledge of market conditions and price changes.
   > Complete information about the products, prices, and means of production.
2. Identical or homognous products.
   > Examples: fruits and vegetable markets.
3. No barriers to entry or exit.
4. Firm’s total revenue = P x Q.
5. If TR = TC, firms would breakeven and be making normal profit.
   > In long run, firms will only supply the market if they can cover all of their costs and make normal profit.
   > The optimum output where AC is the lowest.
   > The long run equilibrium is where the only firms left are the most efficient ones, making normal profit.
   > Firms that participated in the market in the long run are productively and allocatively efficient.
   > Achieve Pareto optimum allocation of resources.
6. If TR > TC, firms will be making abnormal profits.
   > Impossible in the long term due to relatively easy to enter and exit the market.
   > Only in the short run that acts as an incentive for new entry firms. This is because new entry firms will increase the market supply, price of goods will fall then abnormal profit diminish.
7. If TR < TC, firms may exit the industry. But this may not be immediate as firms can continue in production making short run losses, as long as the price received covers AVC.
   > If the revenue is lower than costs in the long run, firms will be exiting the industry.
   > If a lot of firms exit the industry, overall market price will reduce.
8. Low sunk cost.
9. Firms will only make profits if they have different cost structures.
   > This is when they find ways to improve productivity and or lower average total costs.
10. Price takers which have no control over price changes. The firm must accept whatever price set in the market.
    > This is due to huge competition, everyone has perfect knowledge about the goods.
    > Due to this, the demand curve is perfectly elastic.
    > Marginal revenue = Average revenue = Demand
    > Choosing the output is the only decision that a firm has to make.
    > Given the assumption that firms would want to maximise profits, the chosen output will be where Marginal Cost (MC) = Marginal Revenue (MR)
11. Agriculture is the closest industry to this market structure.
    > Farmers do not have influence over the price, each individual makes a small contribution to output, chooses to produce any quantity and sell based on market price.
12. It is a theorectical extreme which acts as a benchmark for real world competition.

Question 11

Monopolistic competition

Answer 11

1. MAny buyers and sellers.
2. Each firm has a slight degree of monopoly power in that it controls its own brand through quality and physical differences (difference design, features).
3. To continue enjoy abnormal profits, firms need to find ways to postpone the long run equilibrium point.
   > In short run, firms in monopolistic competition rely on product differentiation in competing with other firms.
   > Consumers face a wide choice of differentiated products.
4. Firms could develop strong brand image through advertising and promotions.
   > This could reduce consumers’ PED and shift firm’s demand curve to right at the expense of rivals.
   > Therefore, if the firm is successful in building brand loyalty, consumers will not easily shift to rival products.
   > Though advertising may keep the demand curve unchanged, it will increase the firm’s average cost curve.
5. Firms have some influence on the market price and therefore.
   > Price makers.
   > Firms have a sloght degree of market power.
   > Able to raise prices without losing all its consumers.
   > However, due to the large number of close substitutes available in the market, its market power is likely to be weak.
   > Demand curve is downward sloping but elastic.
   > To increase revenue, firms will need to reduce prices.
6. A form of imperfect competition.
   > Competition exists when there are at least two firms in the industry.
   > Competition is imperfect because firms sell products which are not identical to rival firms.
   > Monopolistic commpetition focuses on price and non-price competition to increase their market power.
   » Price competition coud be promotions.
   » Non-price competition could be free gifts, loyalty cards.
7. Few barriers to entry and easy to exit market.
   > Need to break through brand loyalty such as Starbucks.
   > In the short run, profit maximising firms will be seen to make abnormal profit.
   > Monopolistic firms will produce at profit maximising point where MR = MC, produced at P and Q. At this point, firms are making abnormal profit.
   > Price is shown by the AR curve. P is the price set in the market.
   > Cost is shown at the minimum point of ATC. P1 is the cost.
   > Elastic demand due to close substitutes.
   > Over time, low barriers to entry will attract new firms to enter the market.
   » This will affect the demand curve for the existing firms, making the firm’s original demand curve to shift to the left.
   » MR slightly below.
   » Abnormal profit will disappear as more firms enter the industry and lower the price.
   > This process will continue until all firms in the industry are making normal profits.
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   > In the long run, profit maximising firms will only achieve normal profit.
   > Monopolistic firms are productive and allocative inefficient in the short run and long run.
   » Firms do not produce at the minimum average cost curve, hence not productive efficiency.
   » Firms do not produce at P = MC, hence not allocative efficient.
   » This is because they ahve certain market power making them price makers.
   > Examples, PADINI.

Question 12

Oligopoly

Answer 12

1. Few firms dominate the market.
   > Less than 10 firms.
   > Total output is concentrated in the hands of a few firms.
   > Only a few sellers offer similar or identical products.
   » Products may be differentiated or undifferentiated.
   » Selling the same goods but different packaging.
2. High barriers to entry.
3. Market share - shares owned in the market.
4. Can exist in a competitive or interdependent industry.
   > Firms make independent decisions where they decide their market strategy to compete with rivals, but take notice of rivals’ actions.
   > Firms will concentrate on non-price competition to increase revenue.
   » Process innovation to reduce average cost and be able to cut prices without sacrificing profits.
   » Brand proliferation where firm produces lots of brands to leave no gaps for rivals.
   » Market segmentation to create a niche market.
   » Example, Nestle has KoKoKrunch, Milo. It reduced production into smaller firms for easy management.
   > Uncertainty and risk with price competition may lead to price rigidity.
5. Price makers have a higher degree of price control.
   > Could start a price war if competitors are offering lower prices.
   » Offering lower prices is seen as a defensive tactic to protect and gain market share to its rivals, and prevent new entrants.
   » A firm may prepare to sacrifice profits by cutting prices in an attemt to increase or retain market share.
   » Firms also need to highly diversified to offer different products in order to spread the risk and profits from diversification can be used to cover short-term loss.
   > To have the ability to offer lower prices, oligopolists need to have a significantly lower cost than its competitors.
   » Big firms can cooperate with rivals. This can be done through R & D or product innovation.
   » R & D costs are high and change rapidly.
   » Firms are better off by polling their knowledge and agreeing on technical standards.
   » This way, firms are better off by cooeprating rather than competing.
6. Oligopoly firms could grow by taking over one of its rivals.
   > Horizontal integration is when a firm grows through merger or acquisition of another firm in the same sector of industry.
   > Two companies of teh same industry merge or acquire to produce goods together.
   > Examples, Standard Oil Company bought 40 over refineries, Disney bought PIXAR.
7. Traditional model of oligopoly is known as the kinked demand curve where it involves both elastic and inelastic demand.
   > The model is used to explain how firms react to each other’s behaviour.
   > The model assumes that oligopolistic firms are interdependent, meaning that the behaviour of any one firm impacts on the behaviour of all others in the market.
   > Suppose a firm increases its price. This will not be followed by all firms as they have little to gain since their revenue is likely to fall.
   > If the price is reduced, there will be the same reaction from all firms. Again, revenue will fall.
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   > The oligopolist’s best position is at the ‘kink’, where the price is P and Q is being supplied.
   > Any change in costs below P, for example from MC1 to MC2, will not lead to a price increase.
   > Prices will tend to stay the same and to change little over time.
   > The conclusion is that there is price rigidity in the market as indicated wthin the limits shown by the gap LM.
8. No collusion between firms, meaning all of them are independent in setting the price.
   > Collusion is an anti-competitive action where the firms cooperate in secret agreement.
   » Firms may collude to set price, limit production level or investment.
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   > However, informal or tacit collusion is not illegal and usually takes the form of price leadership (follow=the-leader agreement).
   » The objective is to maximise profit for the whole group, by acting as a single monopoly.
   » Price leader could be the one with lowest cost or largest market share.
   » Price leader will set the market price and all firms in the market will accept and follow it.
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   > Cartel
   » Firms in an industry agree to restrict competition between its members to maximise the profits.
   » Firms agree to restrict price or output and act as a single monopoly.
   » By operating as if a monopoly, firms are able to earn abnormal profit.
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   > In reality, it is difficult to identify whether tacit or formal agreements because price similarities can be the result of either aggressive pricing in a competitive oligopoly, or the outcome of collusive agreements.
   » This makes investigations into anti-competitive behaviour difficult.
   » Agencies to check collusion within the firms:
   »> UK: Competition and Market Authority
9. Prisoner’s dilemma
   > To cooperate or not to maximise profit.
10. Examples: telecommunication industry, RedONE

Question 13

Price leadership

Answer 13

A market situation whereby a particular firm has the power to change prices, and the competitors follow the lead.

Question 14

Cartel

Answer 14

A formal agreement between firms to limit competition by limiting output or fixing prices but is illegal.

Question 15

Monopoly (Pure monopoly)

Answer 15

1. Just one firm in an industry but many buyers.
   > A firm controls the entire output of the industry.
   Reality is there will be one to two firms such as Apple and Microsoft.
   > In the UK, a legal monopoly is when a firm has more than 25% of the total market.
2. A local monopoly can exist where a relatively small firm dominates the local market, either because there is high cost, or not profitable.
   > However, domestic monopoly can be broken by new competition such as overseas importer of similar goods and services, or deregulation by the government.
3. Very high barriers to entry.
   > Competitors are prevented from entering the market due to imperfect competition.
   > Example of monopoly in Malaysia is TNB.
   » Only company that provides electricity to households.
   Malaysia government imposed barriers to entry for TNB which is a legal protection as TNB is protected by the licence they obtained from the government to operate their business.
   TNB also owned scarce resources, that is coal.
4. Usually very unique goods or resources that other producers don’t have the ability to access.
   > No close substitutes meaning consumers can only get the product from monopolists.
5. Price maker and has the power to set the price.
   > To sell more quantity, firm must reduce prices and vice versa.
   > They can only control price or quantity of sales, not both to maximise profit.
   > As such, the firm is facing a downward sloping demand curve.
   > A profit maximising monopolist firm would choose output where MR = MC. For a monopoly firm, P > MR = MC.
   > Firm is making abnormal profits, this will be permanent.
   > There is no distinction between short run and long run because of high barriers to entry (no competition at all).
   > There is no economic incentive for monopolists to move away from the profit maximising output and price.
6. Examples: Microsoft and Apple.

Question 16

Natural monopoly

Answer 16

1. Fixed costs contribute to a high percentage of total costs.
   > High fixed costs could deter the entry of competitors as they see it as not profitable to break through the market.
2. To society, duplication of service would be wasteful.
3. As output increases, AFC will decline offering the prospect of benefits gained from economies of scale.
   > ATC will keep falling due to continuous economies of scale.
   > Hence, natural monopoly can be seen as increasing retuns to scale at all levels of output.
   > Therefore, firm experiencing falling LRAC as production expands.
4. Only have short run.
5. A monopoly firm will set profit maximising output where MR = MC.
   > Output at Q1 and price at P1.
   > Firm earns abnormal profits.
6. If a firm behaved like a perfect competition market, the equilibrium position is where P = MC because they are price takers.
   > Output at Q2 and price at P2.
   > Firm is making a loss.
   > Firm would produce at Q2 only if the government provides a subsidy to cover the loss.
   > The alternative is for the service to be provided by the public sector, the government provides the service at a loss.
7. Overall, there is little economic logic to having rival companies under natural monopoly, and the government subsidies are required to keep the output at socially optimum level.

Question 17

X-inefficiency

Answer 17

1. Occur when a perfectly competitive industry turned into a monopoly.
2. A welfare loss above and leads to allocative inefficiency.
3. Monopolists operate on points above the ATC curve, which is referred to as X-inefficiency.
4. Costs are above those experienced in competitive market.
   > Due to high barriers to entry and no incentive to reduce the cost, meaning the firm will not spend much on improving or innovation.
5. These inefficiencies are:
   > Consumer surplus in monopoly is less than in perfect competition due to the higher price that is charged by a monopolist.
   > Producer surplus in monopoly is greater than in perfect competition because the monopolist’s higher price and lower output has taken away some of the consumer surplus.
6. Monopolies suffered from X-inefficiency, a tyoe of productive inefficiency.
   > Firm is not producing at the lowest possible cost for a given level of output.
   > Monopolists do not have the same control over costs, there may be too many workers or capital is not being used efficiently.
   > It is likely that some investment may take the form of erecting barriers to maintain supernormal profit.
   » This will add to costs in the short run and be at the expense of efficiency.
7. There is always the possibility that these inefficiencies are outweighed by the benefits of economies of scale that lower average costs.

Question 18

Contestable market

Answer 18

1. Any market structure where there is a threat potential entrants are free and able to enter the market.
2. The objective of contestability is to bring about the conditions of a perfectly competitive market in any such market structure.
3. Very competitive market.
   > Number and size of firms are irrelevant.
   > Can be small firms but at least have two firms in the market.
4. Have freedom of entry and exit the market.
   > New and existing providers will have the same cost structures as in a perfectly competitive market, meaning there is absence of sunk cost.
   > Low sunk cost because they spend less on R&D as they only follow other firms in the industry. Consumers have perfect knowledge and complete information about the products.
   > Intention is only to earn the highest profit possible to compete in the market.
5. Any cost differences would be a reflection of a decision by the firm to charge a given price.
   > Mechanism must be in place to prevent the use of unfair pricing designed by established firms to stop new firms from entering the market.
6. Cross-subsidisation is eliminated since firms are unable to make profits if they sell any of their services below costs.
   > Eliminated because they want to make the market more competitive.
   > Low or no sunk cost and lack of capital is risky to do cross-subsidisation.
7. Only normal profits earn in the long run.
   > Open to ‘hit’ and ‘run’ basis.
   > New firms will enter if there are abnormal profits to be earned.
   > Oligopolists and monopolists are obliged to offer consumers the benefits that they would receive in a more competitive market, otherwise new firms will enter.
8. A means by which the governmemt sought to deregulate markets.
   > Removal of barriers to entry, opening up the market for competition.
   > To increase output to provide higher quality services and lower prices.
   > Deregulation has been implemented alongside policy of privatisation.
   > All firms are subject to the same regulations and government control regardless of size.
   > Depends on the type of services provided:
   » Necessary goods: the government will remain a monopoly, no deregulation.
   » Not necessary goods: the government will have deregulation to encourage more firms to enter the market.
9. In theory and in practice, even a monopoly can be contestable.
   > There is a pool of potential entrants waiting to enter a market if they see existing firms making abnormal profits.
   > But making abnormal profits depends on the scenario and type of goods (necessity).
   > In the case of a monopoly, if there are no barriers to entry, a new firm moving into the market can have a major effect on the monopolist’s profit.
   > The monopolists are making supernormal profit, and selling output Q at price P.
10. If the market is perfectly contestable, and there are no barriers to entry or exit, these supernormal profits would be a signal for new firms to move into the market.
    > As a result, the monopolist is forced to reduce price to P1 while producing the same level of output in order to maximise the volume of sales.
    > Normal profits will now be earned since average cost equals average revenue, AC = AR.
11. If the monopoly firm changes the price at profit maximising output level, MR = MC, abnormal profits will attract new firms to enter.
    > Monopolists can avoid this from happening is to set price equals to its average cost, P = AC.
    > There are no abnormal profits to be earned.
    > Although the firm made normal profit, no productive and allocative efficiency was achieved.
12. Applications of the contestable market
    > Airline market
    > Telecommunication
    > Natural monopoly

Question 19

Crosss-subsidisation

Answer 19

Using the profit from one goods to cover other goods’ losses.
> Example: Nestle.