Perfect Competition Model
Allocates resources most efficiently and effectively, best allocation for society
* Firms aim to maximise profits
* There are many buyers and many sellers - no individual participant can influence price - price takers
* The product is homogenous - doesnt differ from buyer to buyer
* No barriers to entry/exit - new entrants can join if desired, and can leave the market without hindrance
* There is perfect knowledge
* No externalities
Efficiency in PC
- Productive efficiency - not achieved in short run but in long run - firm does not need to operate at lowest point of AC curve in short run
- Allocative efficiency - achived in PC, as firms set P equal to MC. In the long run, SN profit is comepted away by new entrants - ensures that P = MC
Monopoly Model
Market with a single seller of a good - water companies, British Network Rail
* No substitues for this good, either actual potential
* Very high barriers to entry and exit
* Imperfect knowledge
* Profit max objective
* No competition
Monopolistic Competition Model
- Many small firms - low concentration ratio
- Similar goods, slightly differentiated through quality, branding, advertising - allows firms to build brand loyalty
- Low barriers to entry and exit
- Firms can influence price to an extent becuase they are producing goods that are slightly different from those of rival firms
- Ex chicken shops
Oligopoly Model
- Small number of large firms
- High barriers to entry and exit - economies of scale, legal barriers, control of resources, aggressive tactics, and high competition
- High start up costs on product differentiation, branding, advertising - difficult for new entrants to compete
- Products may be hetergenous or homogenous
- Mutual interdependence - decisions taken by one firm affect other firms, so firms look to study and anticipate rivals moves
Oligopoly - Strategic behaviour
- Based on plans of action that take rivals actions and reactions into account
- Result of mutual interdependence
Oligopoly - Conflicting incentives
Incentive to collude - agreeemnt between firms to limit competition between them, usually by fixing price and lowering quantity - collusion reduces uncertainty from not knowing how rivals will act –> maximise profits for all firms
Incentive to compete - each firm faces incentive to compete with rivals in aim to capture part of their market shares and profits –> increasing own profit at expense of rivals
Oligopoly - Game theory
- Game theory - analysis of behaviour of decision makers who are dependent of one another, using strategic behaviour to anticipate the behaviour of their rivals
- Prisoners dilemma - decision makers who use strategic thinking to guess rivals moves to maximise profits may end up being collectively worse off = Nash equilibrium
- Conflict between pursuit of self interest and collective firm interest - both firms could be better off by cooperating, but by trying to make itself better off, they both end up worse off by cheating
Collusive Oligopoly
Agreement in setting price/output –> gives all parties involved a unfair advantage over rest of the market - allows them to boost profits and reduce uncertainty
Illegal in most countries - works to limit competition
May be formal or informal
Open/Formal Collusion
Cartel - formal agreement between firms in an industry to take actions to limit competition - formal collusion
Limit competition, increase monopoly power and boost profits
* Limiting and fixing quantity sold
* Fixing prices,
* Setting restrictions on non price competition such as advertising,
* Dividing market according to geographical or other factors
* Agreeing to set up barriers to entry
OPEC - 13 oil producing countries, periodically try to raise oil prices by limiting output
Difficulties with Collusion
- Incentive to cheat - a firm that cheats can improve its own market share and profits at the expense of other firms - this results in risk of cartel collapsing, Nash equilibrium
- Cost differences between firms - each firm faces different cost and revenue curves - hard to set a price as firms with higher AC curves make lower profits, but firms with lower AC curves make higher profits; different demand curves due to brand loyalty, advertising - more differentiation, bigger gap in demand curves –> difficulties in agreeing upon a price
- Number of firms - larger number of firms - harder to reach agreement over price and output, due to differing views - agreement and compromise more difficult
- Price war - firm cheating on cartel agreement might result in price war - firms continue to undercut one another - lower prices and lower profits overall
- Recessions - sales fall, profits reduced, firms have stornger incetive to cheat and lower prices
- Entry into industry - large profits attarct new entrants - drive down price setting power of cartels - reduced profits
- Lack of dominant firm - firm with highest market power assumes leadership position - leads negotiations towards agreement
Contestable Markets
For a market to be contestable
* Entrant has access to all production techniques available to incumbents
* Level of barriers to entry/exit must be low
* No sunk costs
* Incumbent firms should not have competitive advantage over new entrants - so these incumbents must not set a price above AC, which will attract new entrants and compete away SN profit (hit and run entry)
* Internet has improved knowledge of market conditions - increased contestability of markets and competitiveness
Contestability - Advertising
- Incumbent firms are more likely to spend more on advertising, building brand loyalty
- Makes it difficult for new entrants to grow and become established
- Reduces contestability
- Counted as sunk costs - cannot be recovered if firm fails
Contestability - R&D
- Some industries undertake heavy R&D programs (pharma industry)
- Contributes to rising fixed costs - new entrants will have to spend heavily on R&D if they wish to keep up with incumbents
- Makes market less contestable
Monopsony
- One buyer, many sellers
- Monopsony power - if a producer only has one/few buyers, these buyers have larger bargaining power (over price+other factors), as the producers have limited choice
- Buyers are more likely to get price reductions
- Price and output lower than competitive conditions
- Example - supermarkets like Tesco and Sainsburys (large market shares) have large monopsony power over suppliers - easier to negotiate discounts and other perks; Tesco controversy - used monopsony power to delay payments to suppliers
- Consumers can benefit from monopsony power - firms could pass on lower costs to consumer
- Sellers make less revenue/profit and struggle to stay in business - reduce quality to reduce costs
Natural Monopoly
- Only ONE firm in the market
- Efficient for only one firm to operate - would be inefficient, duplication of resources and very expensive for other firms to enter
- Incumbent firm would always have lower AC than new entrant - AC and MC continue to drop as output rises
- Extremely high fixed costs and start up costs
- Example - Network Rail - only one firm operates all of the tracks - would be waste of resources to build another set of tracks
Barriers to Entry and Exit
Any obstructions that prevent or hinder a firm fron entering or exiting a market
* Structural - natural barriers such as existence of a natural monopoly; very high fixed/capital costs that hinder a firm from entering; sunk costs arising from capital or advertising
* Strategic - branding and advertising by incumbents can build brand loyalty and make it tougher for new entrants to grow; vertical integration can be used to control supply chains; patents to prevent other firms from using certain production techniques
* Statutory - legal requirements that a new firm has to meet - ex: liquor license
