1
Q
what are the characteristics of a firm in perfect competition
A
large number of firms:
- the firm’s output is small in relation to the size of the industry.
- firms act independently of each other, therefore the actions of one firm doesn’t affect the actions of another, unlike in an oligopoly
identical products:
- the goods being produced in this market are entirely homogenous - it is not possible to distinguish the product of one producer from that of another
free entry and exit into and out of the market:
- any firm that wishes to enter the market can do so freely as there is nothing to prevent it from doing so
- there are no barries to entry or exit from the industry
Perfect resource mobility:
- resources bought by the firms for production are completely mobile
- means that they can easily and without cost be transferred from one firm to another
Perfect information:
- all firms and all consumers have perfect information regarding products, prices, resources and methods of production
- ensures that a firm can’t produce the product at a lower cost without all other firms doing the sam
- also ensures that consumers don’t take a higher price than they should, as they are aware of the market determined price
2
Q
why is a firm in perfect competition a price taker?
A
- the firm is such a small part of the industry that no matter how much it produces at the market price, it cannot influence the market price
- it is a price taker because it has no power over setting the price, therefore it is forced to take the same price set by the market, at all units of output
3
Q
why is it that firms in perfect competition can only make normal profit in the LR?
A
- if firms are making supernormal profits in the short run, then in the long run, new firms will join the market, shifting the industry supply curve from s1 to s2, until it reaches the equilibrium price where normal profits are being made
- since firms in perfect competition are price takers, the new industry price becomes the new demand curve of each firm.
- if firms are still making supernormal profits, then more firms would join the market, shifting the supply curve to the right and lowering the price level further, thus illustrating how normal profits will be reached, as firms will continue to join until supernormal profits aren’t being made any more
4
Q
Can firms make profits in the SR, and why/why not?
A
- firms can make supernormal profits in the short run, because during this time the firm has at least one fixed input, therefore the number of firms is also fixed in the short run
- this means that firms can’t enter or leave the market in the short run, which could have affected profits
5
Q
what are the advantages of perfect competition
A
- productive efficiency in the long run
- allocative efficieny
- low prices therefore for consumers
- x-efficient
- competition leads to closing down of inefficient producers
- market responds to consumer tastes
6
Q
what are the disadvantages of perfect competition
A
- lack of product differentiation for consumers
- not dynamically efficient - limited ability to engage in research and development, so therefore difficult to improve the quality of the goods for consumers
- can’t benefit from economies of scale
- based on unrealistic assumptions
- market failure - in the LR, firms might not satifsy consumer’s interests
7
Q
can firms in perfect competition exploit economies of scale
A
- very unlikely that firms in perfect competition will be able to exploit economies of scale
- this is because firms make a very small proportion of the market and have a relatively small output, so they find it difficult to increase the size of their operations, especially considering that they can only make normal profits in the long run
8
Q
give an example of a market which is close to perfect competition
A
- market for shares (stock market) - within each firm, they are selling a homogenous product, as each share is identical to one another, and they are selling each share at the same price
9
Q
will you find advertising in a perfectly competitive industry
A
- No
- if all goods in perfect competition are supposedly homogenous products, then advertising serves no purpose because there goods are not more appealing than other firm’s goods
10
Q
why is perfect competition unlikely in the real world
A
- firms will want to adapt their good to make it more desirable to consumers, so that they can make more profit - most firms’ business objective is to profit maximise
- perfect information is unlikely, as consumers don’t knwo what a firm’s markup cost on a product will be
- firms never act independently of each other - they make decisions based off the actions of other firms
- very rarely is there free entry and exit from an industry, because entry into an industry requires sunk costs, such as advertising and installing online technology. Exit is also rarely free because products tend to deterioriate in quality over time, and so cannot be sold at the same price that they were bought, especially if they have been used for a long time
11
Q
what are the three characteristics of a monopoly and define them
A
High barriers to entry
- difficult to enter a monopoly market due to economies of scale, branding, legal barriers, and the aggressive tactics that a monopoly might use to deter competition
one dominant firm
no close substitutes
- other firms aren’t providing similar goods, so a monopoly market is devoid of competition
12
Q
what are the different barriers to entry in a monopoly
A
- economies of scale
- branding
- legal barriers
- aggressive tactics
- (control of essential resources)
13
Q
how does economies of scale create a barrier to entry in a monopoly
A
- economies of scale - when as the firm grows the size of its operations, its cost per unit of output falls
- this results in the downward sloping portion of a firms LRAC curve, permitting lower AC curves to be achieved as a firm grows in size
- when economies of scale are extensive, this means that as output increases over a long period of time, costs continue to fall
- this makes it extremely difficult for firms entering the market to compete and be successful, because the monopoly firm will have a much lower cost per unit of output, meaning that it can sell its product at a lower price, while the new entrant, starting at low outputs, will have much higher average costs, and so will be forced to charge a higher price, which will make it uncompetitive
14
Q
how does branding create a barrier to entry in a monopoly
A
Branding
- advertising the product that they are selling influences consumers, generates recognition, and establishes a loyal customer base if the advertisments are convincing
- new firms therefore face a disadvantage, as people will gravtitate towards well known brands
15
Q
how do legal barriers create a barrier to entry in a monopoly
A
Patents
- legal protection over an idea or an invention
Copyrights
- protection over something you have produced
- copyrights used for arts, music, literature, while patents used to prevent others stealing technological innovations
- disadvantage for new firms, because it means that they have to build their product from scratch, and invest in research and development so that they can create their product
16
Q
how does control of essential resources create a barrier to entry in a monopoly
A
- monopolies can arise from ownership of an essential resource
- e.g., DeBeers controls 50% of the world’s diamond mines, meaning that new firms will struggle to access the resource
17
Q
how do aggressive tactics create a barrier to entry in a monopoly
A
- cutting prices
- advertising aggressively
- threatening behaviour
18
Q
why will the monopoly firm not produce any output in the inelastic portion of its demand curve
A
- when PED is >1 (elastic), then cutting prices increases total revenue
- when PED <1 (inelastic), then cutting prices decreases total revenue
- TR is maximised where PED= -1
19
Q
what is a natural monopoly
A
Natural monopoly
- when a firm can benefit from economies of scale so large that it is possible for the single firm alone to supply the entire market at a lower average cost than two or more firms
- it is more efficient for a single firm to produce this good, than multiple firms, due to high fixed costs and low marginal costs
- if the market demand for a product is within the range of falling LRATC, this means that a single large firm can produce for the entire market at a lower average cost than two or more smaller firms
20
Q
give examples of a natural monopoly
A
- thames water
- UK power networks
21
Q
why is it even more difficult for new firms to enter a natural monopoly
A
- barriers to entry will be even higher
- this is because the monopoly firm has benefitted from vast economies of scale, while new firms have much lower output and much higher costs per unit of output
22
Q
what are the causes of such a large range of falling costs in a natural monopoly
A
- significant structural costs
- once the main infrastructure has been created, such as with a pipe network, it becomes much easier and cheaper to supply water to one more house, meaning that the marginal cost in a natural monopoly will be quite low once high levels of output have been achieved, becaause the water company only has to add one pipe in order to increase output
- similarly, once an electricity network has been created, the marginal cost of supplying electricity to one more household is much less than it is for new entrants.
- therefore, the average cost per unit gradually falls
23
Q
why is the water supply in the south east most likely to be controlled by a natural monopoly?
A
- most efficient number of firms in this industry is one firm.
- better for consumers
- one firm can achieve lower long run average costs if they control the whole of the market, than 2 firms could controlling half of the market each
- this will occur because the entire demand for the product falls within the range of falling LRATC.
- fixed costs are high, because it usually involves building a network, incurring high infrastructure costs
- but the marginal cost of adding a pipe will be low
24
Q
economies of scale in a monopoly?
A
- economies of scale - as output increases and the size of the firm grows, average costs decrease.
- allows them to lower costs and therefore charge a lower price, and produce a higher quantity
25
what are the advantages of monopoly power
Advantages of abnormal profit:
- dynamic efficiency gains - profit enables monopolist to invest in research and development, and thus achieve a more efficient allocation of resources in the long run
- better quality products for consumers - R and D can lead to better quality products for consumers
- lower prices for consumers - may be investing in capital goods, which lower average costs, by being more productive
Advantages of a natural monopoly:
- makes the most sense for some goods/services to be produced by one individual firm
- it is more efficient for a single firm to produce this good, than multiple firms, due to high fixed costs and low marginal costs
- if the market demand for a product is within the range of falling LRATC, this means that a single large firm can produce for the entire market at a lower average cost than two or more smaller firms
- avoids undesirable duplication of services which would create a misallocation of resources
- natural monopoly gives a chance for lower prices for consumers
- talk about vast economies of scale that natural monopolies in particular can access
26
what are the disadvantages of monopoly power
Disadvantages of abnormal profit
- x-inefficiency - especially in a monopoly, there is less of an incentive to be efficient due to the lack of competition. Consequently, the firm's costs may be higher than the average total cost curve that it could be producing on, because at every level of output, it is less efficient
- for instance - not working as hard to make the production process as efficient as possible, so workers aren't as well trained and management of the process may be poor
disadvantages of a monopolies: inefficiency:
- fail to achieve allocative or productive efficiency
- welfare loss for consumers due to no allocative efficiency
- good being under consumed
- for allocative inefficiency, price in a monopoly is being set above marginal cost, therefore the price is above the marginal cost of providing the good
27
what is price discrimination
Price discrimination
- charging a different price to different consumers even though the price difference is not justified by a varying cost of production
28
what is first degree price discrimination
- discrimination among individual consumers
29
what is second degree price discrimination
- discrimination based on quantities purchased
30
what is third degree price discrimination
- discrimination between consumer groups that have different price elasticities of demand for the product.
- enables monopolies to make greater profit, as shown by the elasticities diagrams in green book
31
what are the conditions needed for a firm to practise price discrimination
- must have some degree of market power
- must be groups of consumers with different elasticities of demand for the product
- must be able to separate out the groups of consumers to avoid the possibility of the other groups buying at a lower price - must be separated on the basis of time, geography, age, income etc
32
what are the advantages of price discrimination
improved profits:
- price discrimination results in higher profits for monopolists, which can improve dynamic efficiency if the profits are reinvested
new customers:
- enables people who have more elastic demand for the product to access it at a lower price, bringing in new customers
potential for cross subsidy of activities that bring social benefits
- charging lower prices for medicines in lower income countries
33
what are the disadvantages of price discrimination
disadvantages of improved profits
- might encourage laziness
- aggressive tactic - can be used to drive out rival firms, thus reducing competition
bad for consumers
- extraction of consumer surplus in exchange for higher producer surplus
- majority will pay above the marginal cost - many will end up paying more than they did before
34
define monopolistic competition
Monopolistic competition is a market structure which combines elements of monopoly and competitive markets
It involves many firms selling goods which are similar, but not perfect substitutes
35
what are the characteristics of monopolistic competition
- low barriers to entry and exit
- large number of small firms
- slight product differentiation - therefore firms are price makers, but only slightly due to substitutes, therefore they have price elastic demand
- non-price competition
36
what is an exmple of an industry with monopolistic competition
- corner shops, independent cafes, hairdressers
37
what happens in the short run with monopolistic competition
- in the short run, firms are able to make supernormal profits
- their AR and MR curves will be more price elastic, due to availiabiliity of close substitutes
38
what happens in the long run with markets in monopolistic competition, and how can this be evaluated
- in the LR, supernormal profits will be eroded, because they will profits in the short run will incentivise new entrants into the market, which is possible due to low barriers to entry and exit.
- REDUCES DEMAND FOR EXISTING FIRMS
- this increases the industry supply curve, shifting the firm's average revenue curve inwards until normal profit is being made
EVALUATION
- in reality, there may be imperfect information, meaning that other firms won't be aware that supernormal profits are being made
- firms within the market may also have different sizes, and so may be able to maintain supernormal profits longer than others
39
what are the advantages of monopolistic comp
- in the long run, we get greater product differentiation - positive externality of new firms entering the market
- advertising encourages healthy competition between firms
- no excessively high prices - elastic demand for goods
- lots of product variety is good for consumers
40
what are the disadvantages of monopolistic comp
- no allocative efficiency, as at this level of output, the price is greater than the marginal cost.
- this means that the value that consumers place on the last unit bought is greater than the cost of producing that unit, so the good is being underproduced
- this creates a welfare loss to consumers in the area shaded, because between the profit maximising level of output and the allocatively efficient level of output, the price is always above the marginal cost
- the price of the good is too, high, and the quantity too low
no productive efficiency - not producing at output where average total costs are lowest
no dynamic efficiency - no supernormal profit
- advertising in M.C. means increased costs for firms, and therefore increased prices for consumers
41
TWE is a monopolistic market contestable?
Yes
- very few sunk costs due to low barriers to entry and exit
No
- building brand loyalty is arguably a sunk cost - entrants will have to advertise in order to build a customer base, which is a sunk cost
42
what do normal profits signify
- there should be no incentive for new firms to enter, or for existing firms to leave the market, when normal profits are being made
- this is because the opportunity cost of a firm's resources at this output is zero, therefore, only the same profit can be earned by the firm at its next best alternative
43
define an oligopoly
A market made up of a small number of large firms with a high concentration ratio selling differentiated products, and competing with each other.
44
what are the main characteristics of an oligopoly
small number of large firms with a high concentration ratio
- majority of the industry's output is concentrated among a few firms
large barriers to entry and exit
- there are very high sunk costs - due to non-price competition
- imperfect information
- economies of scale
- legal barriers to entry
- aggressive behaviour - predatory pricing
interdependence
- the way in which one firm acts affects the decisions of others
- for instance, a firm may have improved the quality of its good, or lowered prices, which could massively affect the demand curve of other firms
product differentiation
- the goods that each firm sells will be differentiated - will be the same product, but they will have variations which may make them more or less attractive
- e.g., cars
45
what is the n-firm concentration ratio
- measures the COMBINED market share of the largest n firms
46
how can concentration ratios be evaluated - useful or not useful in determining whether a market is an oligopoly
- the parameters which decide which firms are part of the same market may be damaging to the concentration ratio - e.g., putting the Sun and Financial Times in the same newspaper CR, even though they have very different readers
- the CR data may be misleading - e.g, the four firm CR may be 80%, which may suggest this is an oligopoly, but if the largest firm has 75% market share, then this is a monopoly. the same 4-firm CR could be distributed with each firm having 20% market share, suggesting there is more competition between these 4 firms
47
what are the conflicting incentives in an oligopoly
- incentive to collude vs incentive to compete
- incentive to compete - want to take greater market share than all rivals, and outsmart competition, delivering the best quality product
48
what is collusion?
- an agreement between firms to limit competition to increase profits, ussually by raising prices and lowering the quantity produced. By colluding, they avoid uncertainty that arise from the interdependence between firms
49
what are the incentives to collude
profits
lack of uncertainty
- avoids constant changes in demand which arises from product differentiation and the interdependence between firms
50
what are the incentives to compete rather than collude
- could get caught for collusion - CMA examples
(although difficult to catch informal collusion)
- morally wrong - don't want to exploit consumers
- desire to outsmart competitors, innovate, and gain a greater market share and profits by selling better quality products
51
explain the kinked demand curve in an oligopoly
- firms find it difficult to increase their price
- above their current price, increasing the price will decrease revenue because the demand curve becomes price elastic
- below their current revenue, the firm's demand curve is more inelastic
- therefore, decreasing the price will decrease revenue, because other firms will follow, leading to a price war
- don't get that many more customers, as other firms will probably also cut their prices
52
what are the three different pricing strategies
- price wars
- limit pricing
- predatory pricing
53
price wars - explain
- when firms repeatedly undercut each others prices in order to attract more consumers than one another
- good for buyers in the SR - lower prices
- bad for firms - lower profit margins
54
limit pricing - explain
- where firms set prices at a low limit, in order to deter new entrants into the market
- price must be higher than or equal to normal profit, but low enough so that new firms aren't incentivised to join the market
- the higher the barriers to entry, the higher the limt price can be
- downside - less profits
55
predatory pricing - explain
- when a firm sets its price level below the cost of producing the good
- attempting to force rivals out of business, then they put their price back up
- ILLEGAL IN UK
56
what are the types of non-price competition
- advertising - creates awareness of the company and attracts consumers, which can increase sales and market share, and boost profits in the long run. Advertising can make the demand for the good more inelastic, by making the good more attractive to consumers
- loyalty cards - ties consumers to a specific company, encouraging consumers to stay with a brand because they can get special deals, meaning they think that they are gettng things cheaper
- quality - a firm whose products are of good quality may be able to charge higher prices, and may also make the demand for its good more price inelastic. The quality of the product might make people recommend the product, improving its reputation, and boosting sales of the product
- customer service - helps to give assurance to customers, making them more likely to buy your good, especially if they are deciding between companies which supply similar goods at similar prices, because good customer service could mean that the product will get replaced if broken - two year warrantee - e.g., John Lewis
- product development - gives competitive advantage, as improves the quality of the product
57
what is a cartel
a formal agreement between firms in a particular industry to limit competition with the aim of increasing profit
58
what are the obstacles to maintaining a cartel
- the incentive to cheat - other firms can make greater profit if they undercut the fixed high price which has been decided
- cost differences between firms - difficult to agree a common fixed price between colluding firms because it is unlikely that they will all have the same average cost curves, therefore, the higher the price, the greater the disparity in profits between colluding firms
- firms will face different demand curves - firms have different market shares, and product differentiation means that even if firms agree to a fixed higher price, consumers will always gravitate towards one firm more than another
- degree of market power - for collusion to be successful, the colluding firms have to both have a similar, and large degree of market power.
- number of firms - Also, if there are a large number of firms in the cartel, it will become extremely difficult to reach an agreeable price for everyone, because of the factors mentioned above - different cost curves, demand curves, so each firm will be making different amounts of profit, therefore some firms will benefit more from collusion than others - if some firms make more profit, then they will have greater opportunity to invest or spend this money gaining an even greater competitive advantage.
- recessions - in a recession, sales will be reduced for everyone, giving firms a greater incentive to cheat
- potential entry into industry in which collusion is occurring - if potential entrants see that large supernormal profits are being made, then this will increase the number of firms in the industry, as supernormal profits will act as an incentive. as the number of firms in the industry increases, the firms in the cartel will have a lower demand curve, as the same number of consumers will be distributed across a greater number of firms
59
what is game theory - how can it be used to evaluate interdependent behaviour in an oligopoly market
Game theory
- a mathematical technique used in analysing the behaviour of decision makers who are dependent on each other, and who use strategic behaviour as they try to anticipate the behaviour of their rivals
60
what is the nash equilibrium
- this is where each firm will be the least worse off in a payoff matrix
- no one has anything to gain by changing only one's own strategy
- this is where two firms in competition are likely to end up, given they know that if they both choose a high price strategy and collude, and the rival firm then sets a lower price, this could result in the firm making lower profits than it is already
61
what are the advantages of an oligopoly market
Benefits of abnormal profits
- dynamic efficiency gains - the idea that in the long run, reinvested profits will help to achieve an efficient allocation of resources
- threat of competition means that oligopoly firms are likely to reinvest a large proportion of its profits into R and D, resulting in better quality products for consumers
- due to competition and interdependence between firms, their aim is to attract as many consumers as possible - firms are constantly factoring in the needs of consumers.
benefits to consumers
- economies of scale
- (also dynamic efficiency)
- product development means that consumers will have a greater choice of products, because firms aim to make their g
- kinked demand curve - arguably cant set excessively high prices, as if they raise the price, this will often reduce total revenue
62
what are the disadvantages of an oligopoly market
- no allocative or productive efficiency
- collusion - exploitation of consumers
63
what are the advantages of advertising
- provides consumers with information about different products
- creates healthy competition between firms
- the best advertisements are the ones which appeal the most to consumers - firms are incentivised to improve the quality of their good and also reduce their price, so that they can advertise about this and boost sales
64
what are the disadvantages of advertising
- increases CoP for firms, which in turn increases prices for consumers
- successful advertising gives firms greater monopoly power
- advertising can create a large barrier to entry - new firms can't match this huge sunk cost
- advertising often deceives consumers into thinking that a good is more attractive than it really is
- advertising may increase the price inelasticity of demand for a product, meaning that firms might increase the price in order to increase total revenue
