5. Market structures

The structure of a market is described by…

…by the number of firms, the degree of product differentiation, and the extent of barriers to entry

The objectives of firms…

List the 4 assumptions of perfect competition

1. Large number of buyers and sellers who are all small and independent, and are therefore unable to influence the market price/are price takers.

2. Identical products

3. No barriers to entry/exit

4. There is perfect knowledge of prices

What is the model of perfect competition useful for?

It provides a yardstick for judging the extent to which real world markets perform efficiently or inefficiently, and the extent to which a misallocation of resources occurs.

It is a purely theoretical model.

Give two industries that are close to being perfectly competitive

1. Currency exchange: identical product, excellent price transparency, lots of small buyers and sellers who are price takers, low sunk/setup costs. However, there are some sunk costs and MNCs and large governments can influence prices of their currency.

2. Agricultural product, e.g. Granny Smith apples: identical product, lots of buyers and sellers, good price transparency. However there are some setup costs, e.g. buying land, and supermarket branding can differentiate products

Draw the perfect competition (PC) diagram in the long run and list all the things to mention when analysing it.

• Output level: where MC=MR, assume that firms in PC aim to PM

• Price level: price is determined by the interaction of D and S in the market. Firms are price takers of the market price and cannot change the price without losing all demand so the demand curve is perfectly elastic.

• Cost curves

• Productive and allocative efficiency: yes

Explain the demand curve and the price level in PC (long run)

• All buyers and sellers are small and independent (concentration ratio is 0) → have no price setting power and are price takers of the market price → D curve is perfectly elastic

• AR curve is constant and MR curve is also constant as each additional product is sold for the exact same price, i.e the market price.

• No reason for customers to be loyal as there is 0 product differentiation + perfect knowledge of prices → increasing P above market price = demand becomes 0, lose all customers.

• No point charging less than P because firm is too small to cope w/ the additional demand and can’t afford to earn less than normal profit in the LR

Explain cost curves in PC

• In the SR cost curves fall due to increasing marginal returns and in the LR due to EOS. In the SR they rise due to decreasing marginal returns and in the LR due to DEOS.

• MC must intersect AC at its lowest point

Explain economic profit in PC (long run)

• We can see the economic profit where the PM point meets the AR curve and where it meets the AC curve and the difference between them.

• Firms in PC earn normal profit in the LR, as at the PM point AR=AC, so TR=TC. The opportunity cost is included in total costs so an accounting profit is made, but it is not greater nor smaller than the next best allocation of resources.

Explain economic efficiency in PC

• Yes productively efficient because firms produce at lowest AC, and need to in order to earn at least normal profit.

• Yes allocatively efficient because firms produce where P=MC. This has to occur as they 1. Produce where MC=MR 2. P=MR (due to being price takers) 3. P=MC.

• Dynamic efficiency: it’s possible, but more difficult than in markets like a monopoly because they don’t earn SNPs in the long run which can be used to invest in R&D

Explain why SNPs/subnormal profits may exist in the short run, but not in the long run

Advantages and disadvantages of PC

Advantages	Disadvantages
In the long run, there is a lower price. P=MC, so there is allocative efficiency.	In the long run, dynamic efficiency might be limited due to the lack of supernormal profits.
Since firms produce at the bottom of the AC curve, there is productive efficiency.	Since firms are small, there are few or no economies of scale.
The supernormal profits produced in the short run might increase dynamic efficiency through investment.	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

List the 3 assumptions of a monopoly market

It is an imperfect market structure on the opposite end of the scale to perfect competition.

1. One single producer of a good with 100% market share (pure monopoly) but a working monopoly is a firm w/ >25% market share and a dominant firm has >40%.

2. High barriers to entry → firms have price setting power

3. Firms are profit maximisers

Define barriers to entry and give the 3 types of barriers

Obstacles that prevent new firms from joining the industry. They block the signalling function and protect the market share and SNPs of the monopolist.

1. Legal barriers

2. Structural barriers

3. Strategic barriers

Explain legal barriers to entry

• Nationalisation of industries effectively makes them into monopolies, such as water companies (only 12 exist in the UK)

• Government license: UCAS is the only firm who manages university admissions due to license from the govt. Also Royal Mail which has UPS obligations from the govt.

• Intellectual property rights: having an original design/product/process entitles a firm to a patent which gives them the legal right to be the sole producer (e.g. pharmaceuticals)

Explain structural barriers to entry

• These are unintentional barriers

• High setup costs and huge EOS potential (e.g. network) → high MES for the industry that new, small firms cannot reach quickly → they face higher AC → higher prices → struggle to compete → barrier to entry.

• Lack of access to resources due to climate etc.

Explain strategic barriers to entry

• Intentional barriers to entry put into place by existing firms to protect their market share

• Advertising: firms invest heavily in logos, slogans, ads, sponsorships etc. to strengthen their brand power and make the PED for their products more inelastic (e.g. Apple AirPods)

• Limit pricing: e.g. Coca Cola. They sell at a price that’s high enough to make a profit, but low enough to make it difficult for new firms (with higher prices) to compete

• Predatory pricing: this is illegal but not easy to catch by regulating bodies like the CMA. Existing firms lower their price when threatened by a new competitor to become more competitive, then raise prices again after forcing the competitor out.

• Brand proliferation: when a firm owns multiple brands in the same market, to give the false idea of lots of competition

Give examples of monopolistic markets and the source of their monopoly power

• UCAS: Govt license

• Pharmaceuticals: patents

• Water industry: regionalised monopoly

• Cable TV/Netflix/Spotify: structural barriers

Draw a long run monopoly diagram and list the different points to mention and analyse

• Output level: produce where MC=MR at a restricted level of output

• D=AR: inelastic due to lack of subs but not perfectly inelastic as ppl can choose to go without

• MR: falls at a quicker rate than AR because not weighed down by all previous sales

• cost curves shaped the same way for the same reasons (EOS and marginal returns)

• productive, allocative and dynamic efficiency

• SNPs maintained due to Bs to E

Explain the D=AR curve in a monopoly and their output level

• Inelastic due to a lack of subs. Monopolists can increase P by a large percentage and only lose a smaller percentage of customers. But it isn’t perfectly inelastic as people can still choose to go without.

• Output level is intentionally restricted to ensure higher prices and don’t exploit all EOS.

Explain economic profit in the LR monopoly diagram

Firms earn supernormal profit in the LR because at the PM point, AR>AC so TR>TC. SNPs are maintain due to Bs to E blocking the signalling function, which would normally allow new competitors to enter the market and push down the P.

Explain economic efficiency in a monopoly

• Productive: no, because they don’t produce at the lowest point of LRAC. They don’t fully exploit all EOS as they intentionally restrict output to keep prices high. Also, managerial slack may occur which means that firms lack the incentive to be fully cost-efficient due to the SNPs and lack of threat to market share.

• Allocative: no, because P>MC at PM point

• Dynamic efficiency: it depends. They have the SNPs needed for investing into expensive R&D, and confidence to invest due to Bs to E and therefore safety of their market share. However this may also mean they are apathetic towards innovation due to lack of competitive threat.

The short run profit diagram looks exactly the same as the LR diagram in a monopoly. Why will a short run profit always be maintained in the LR?

Although SNPs act as a signal for new firms to join the market due to the profit motive, Bs to E stop this from working and SNPs are maintained in the LR.

Explain a short run loss in a monopoly

In the SR, a monopolist can make subnormal profit where AC>AR so TC>TR. They will try to find a way to cut costs but if this isn’t possible then they’ll simply leave the market

Give an example of a monopolist using their SNPs/market power to reinvest into innovation and NPD

Google has 90% market share in the search engine industry. They have been able to reinvest their SNPs to develop chromebooks as well as innovating new technology in the AI sector with the new Nano Banana AI model

Give the arguments against a monopoly and why government intervention may be needed to break up the market and make it more competitive (7)

1. Their decision to restrict output -> some customers unable to access the good or service, and those that do must pay a high price which comes with a large opportunity cost and have less disposable income left over for other things

2. Lack of choice and variety for customers -> worsened consumer welfare

3. High prices worsen consumer welfare and these prices are maintained in the long run

4. Monopolists can PD by charging higher Ps to consumers with a more inelastic PED -> replaces consumer surplus

5. Lack of productive efficiency. Intentionally restrict output to ensure a high price -> fails to exploit all EOS and managerial slack occurs due to lack of competitive threat -> lack of incentive to cost-minimise -> prod. Inefficiency

6. Lack of allocative efficiency as P is much greater than MC at PM point, made worse by PD

7. Possible lack of innovation and NPD due to complacency and lack of competitive threat

Potential benefits of a monopoly

1. A monopoly can have higher output and lower prices than if it were to be in a more competitive market. Because the industry has high setup costs and huge EOS potential (e.g. network) -> high MES which a large monopolist can reach but smaller firms cannot -> face higher ACs -> higher prices. Large monopolist can exploit the EOS -> lower AC -> more productively efficient as closer to lowest point of LRAC -> can charge lower prices -> more allocatively efficient -> increases consumer surplus

2. High tax revenue for the govt through corporation tax

3. Benefits of PD (e.g. cross-subsidisation)

4. More NPD and innovation due to having high SNPs needed for investment and confidence to invest due to Bs to E. Essential in pharmaceuticals and technology markets

Compare a monopoly to a more/perfectly competitive market (negatives of mon/benefits of PC)

• Monopoly bad because restrict output to exploit inelastic PED, earn high SNPs in the LR at the expense of consumer welfare. They sacrifice economic efficiency for selfish gain.

• Meanwhile in more competitive markets, there’s more choice, higher output, lower prices and in PC they only earn NP in the LR so are both productively and allocatively efficient.

Draw the diagram which illustrates the problems of monopoly and benefits of PC.

Remember not to draw AC as we are not trying to show profit, just comparing price and output. Also, don’t make the mon. revenue curves too inelastic.

Now draw the diagram which illustrates the potential benefits of monopoly.

• The SM (selfish monopolist) will PM at a low level of output of QSM and have a high price of PSM, whereas a PC firm will PM at a lower price of PPC and higher output of QPC.

• However, it also shows the potential of a monopoly if the don’t act selfishly. In markets with a high MES, they can exploit lots of EOS -> cost curves shift out -> capable of a lower price of PGM and a higher output of QGM.

Defending a concentrated industry (i.e. firms with monopoly/oligopoly power)

when there’s a high setup cost and high EOS potential, resulting in a high MES. Argue that it’s not beneficial to break up a market and make it more competitive, but instead that intervention should focus on legislation/regulation, which would force the firm to act like a good monopolist rather than a selfish one.

How market entry can occur (argument against intervention in the market)

• A monopolist will continue to earn SNPs in the LR because high Bs to E block the signalling function.

• However, you can argue that the signalling function will eventually occur. E.g.:

1. patents eventually expire, allowing new firms to make generic copies

2. govt license may be removed if the firm is performing poorly

3. excessive PD can create bad PR and give opportunities for other firms who don’t play by the existing rules and don’t PD (budget gyms/airlines)

4. globalisation means that a big foreign competitor can enter the domestic market

5. a big business can diversify into a new market (e.g. Virgin with their mobile phone service but also trains)

Define price discrimination and the conditions necessary for it to occur

• This involves charging different prices to different customers for exactly the same product and not due to differences in COP.

• Firm must: have price-setting power (and therefore large market share); identify different groups of customers with different price elasticities of demand; be able