2.5 - a/symmetric information, market structures, profit & loss, game theory, collusive and non-collusive, concentration ratio

perfect/ symmetric information

all consumers and producers have equal access to all relevant information

• optimal decision-making

imperfect/ asymmetric information

one party in a transaction has more/ better information than the other

• suboptimal decision-making

government responses to assymetric information

• regulation

• provision of information

• licensure (obtaining a license by service/ good provider)

private responses to asymmetric information

• screening/ research by buyers

• signalling by sellers

  • eg. warranties, brand name, service records

moral hazard

• one party takes risks

• doesn’t face full costs of the risks

• the full costs are borne by the other party

• eg. insurance

market structures

• perfect competition

• imperfect competition

  • monopolistic competition

  • oligopoly

  • monopoly

perfect competition

• many small firms

• homogeneous products

• no barriers to entry or exit

• no market power

• perfect knowledge

• perfect competition

  leading to optimal outcomes for consumers and producers.

eg. agriculture

imperfect competition

market structure where individual firms have

• some control over price

• product differentiation

• potentially inefficient outcomes.

monopolistic competition

• many relatively small companies

• differentiated products

• low barriers to entry

• some market power

• imperfect knowledge among consumers

• good amount of competition

eg. restaurants, computer games, books, furniture

oligopoly

• few large companies

  • mutual interdependence

• differentiated or homogeneous products

• high barriers of entry

• significant market power

• imperfect knowledge

• some competition

eg. cars,household appliances, detergents, cereal

monopoly

• one large company

• unique product

• no close substitutes

• high to impossible barriers of entry

• complete market power

• imperfect knowledge

• no competition

eg. public utilities

marginal costs MC

change in total costs resulting from additional unit produced

marginal revenue MR

the increase in revenue resulting from an additional unit produced

abnormal profit in perfect competition

• in short run

  • profits will always return to long term equilibrium

• total revenue > total costs

moving abnormal profit to normal profit in long run for perfect competition

abnormal profit → -firms making abnormal profit loose $ - new entrants attracted by profit opportunities -no barriers to entry → normal profit → - firms making losses leave - firms that stay make more profit → abnormal profit ….

profit loss in short run in perfect competition

• total revenue < total costs

moving from loss in short term to normal profits in long run in perfect competition

• if firms in perfect competition make losses in the short run they will shut down

  • shut down rule:

    • if average revenue = average costs, the firm should shut down

allocative efficiency in perfect competition

• allocative efficiency → AR=MC

  • consumers and producers get maximum possible benefits

  • no excess demand/supply

  • no one can be better off without the other being worse off

• average costs are minimised

• no waste

• high productivity

barriers to entry for monopoly

monopoly → 25% or more of the market

• legal (patent/license/ copyright)

• aggressive competition

• economies of scale of existing companies

• control of scarce resources

• natural/ cost barriers

monopoly vs perfect competition graphs

benefits of monopoly

• super profit allows investment in research and development

  • may have lower prices

• economies of scale

• natural monopoly

disadvantages of monopolies

• no need to be more efficient

  • stifled innovation

  • no incentive to improve quality

• higher price

• lower output

• loss of consumer and producer surplus

• welfare loss

• allocative inefficiency

• market failure

• negative impact on distribution of income

ways of dealing with monopolies

• anti- trust laws to break up a monopoly

• mandatory pricing regulations imposed by governments

  • price controls

• competition policies

natural monopoly

when a single firm can provide a good or service at

• lower cost than multiple competing firms

  • due to high fixed costs and economies of scale.

reasons for economies of scale

• specialisation of labor

• specialisation of management

• bulk buying

• financing economies

• spreading of costs

reasons for diseconomies of scale

• co-ordination and monitoring difficulties

• communication difficulties

• poor worker motivation

oligopoly strategic behavior (due to interdependence)

based on plans of action that take into account rivals’ possible courses of action

incentives in oligopoly market

conflicting incentives

• incentive to collude (agreement between firms to limit competition between them)

• incentive to compete/ cheat

game theory

analyses and displays the behavior of decision-makers who are dependent on each other

• their behavior may trigger price wars

game theory graph/ payoff matrix

Nash equilibrium

final position that results from the game

non-price competition in oligopoly

• product development

• advertising

• branding

• quality customer services

• warranties

• provision of credit

• discounts on upgrades

collusive oligopoly

a market structure where firms collude to

• limit competition

• increase market power

• maximize joint profits.

eg. cartels → OPEC

ILLEGAL due to its anti-competitive nature.

informal collusion

where firms coordinate their actions

• without a formal agreement,

  • through signaling

  • tacit understandings

to achieve similar objective

price leadership collusion

informal collusion

• one leading firm sets prices that other firms in the industry follow

• effective coordination of pricing strategies

  • without explicit agreements.

non-collusive oligopoly

firms compete without colluding, resulting in

• independent pricing

• independent production decisions.

concentration ratio

a measure of the market share held by the largest firms in an industry

• concentration ratio ↑ = competition in industry ↓

** if 4 largest firms control 40% of the output an industry is considered oligopolistic

weakness and usefulness of concentration ratios

• do not reflect competition from abroad

• no indication of the importance of firms in global market

• do not account for competition from other industries

• do not distinguish between different possible sizes of largest firms

disadvantages of oligopoly

• welfare loss

• allocative inefficiency

• market failure

• higher prices and lower quantities of output than under competitive conditions

• loss of consumer surplus due to higher prices

• negative impacts on the distribution of income

• possibly less innovative

benefits of oligopoly

• economies of scale due to large size

• product development and technical innovations due to high abnormal profits

  • improved efficiency and lower costs

  • increased product variety