Topic 5: Perfect Competition, Imperfectly Competitive Markets and Monopoly

characteristics of perfect competition

many buyers and sellers, price takers (many small firms) - price driven by the market, no barriers to entry and exit , perfect knowledge (buyers and sellers have complete knoweldge on the prices, quality, and available products. So, there's no information gap, and that helps make the market super efficient.), homogeneous products (identical), FRP is actually short for free resource portability perfectly mobile (labor or capital—can move freely between firms or industries. dynamically effeicient) , firms are short run profit maximisers (they just keep producing up to the point where every extra unit is only just covering its cost. Beyond that, they'd lose money, so that's where their profit maxes out)

perfect competition diagram analysis in short run

The firm is a price taker, and it accepts the industry price of P1. In the short run, the firm produces an output of Q1. The yellow shaded rectangle shows the area of supernormal profits earned in the short run. It is assumed that firms are short run profit maximisers.

AC - average cost - variable costs are costs that change with the level of output—things like materials or labor per unit. Fixed costs, on the other hand, are constant no matter how much you produce—like rent or equipment.

when you're producing more, those fixed costs spread out, so average cost falls. But after a certain point, you run into diminishing returns—your variable costs rise faster. So, after that low point, average cost starts going back up, creating that U-shape. so diminishing returns basically means that after a certain point, each extra unit of input—like labor or capital—gives you a smaller increase in output. So, at some point, adding more just gets less and less efficient, and that’s why your costs start to rise again

perfect competition diagram analysis long run

abnormal profits means now firms have higher incentive to join the market. This causes the supply in the market to increase, as shown by the shift in the supply curve from S to S1. The price level in the market falls as a consequence. Since firms are price takers, they must accept this new, lower price. comp pressure in LR so firms only make normal profits (Normal profit in economics is the minimum level of earnings required to keep a firm operating in its current industry, occurring when total revenue equals total costs (\(TR = TC\))

supernormal profit is any profit above a normal level—basically, it’s extra. Normal profit is just the minimum needed to keep a firm in business

Long run - more firms enter due to low barriers to entry - increasing supply - decreasing the price equilibrium till firms make normal profit where MR=MC - firms earn just enough to cover their opportunity cost - firms have not incentive to stay in the LR - so supply decreases - therefore stabalizing the prices.

Opportunity cost - what you give by choosing another product or use of resources, once firms only make normal profit, that means they aren’t missing out on anything better, it’s earning just enough to keep them in the market. But if another market offers a higher return, then they would leave

advantages of perfect competitive market

lower price in LR - minimum possible price, productive efficiency - firms try to produce at the lowest possible cost, therefore using their resources efficiently, dynamic efficiency in SR - supernormal profit give firms the boost to invest in R and D that drive for profit pushes them to innovate, boosting consumer welfare are efficiency.

disadvantages of perfect competition

Economies of Scale are cost advantages that firms experience when they increase production, resulting in a lower average cost per unit as fixed costs are spread across more output.

limited dynamic efficiency in LR, few economies of scale since firms are small, advertising + externalities + product differentiation means not applicable in real life.

• firms might not have any incentive to improve product quality since everything’s completely identical.

• 1. Limited dynamic efficiency in the long run

  Firms in Perfect Competition make only normal profit in the long run, so they may have less incentive to invest in research and development. This can reduce innovation and technological progress, leading to weaker dynamic efficiency.

  2. Few economies of scale

  Because firms are very small, they cannot fully benefit from large-scale production. This means they may miss out on economies of scale, so costs could be higher than in larger firms in other market structures.

  3. Lack of product differentiation

  Products are identical (homogeneous) in Perfect Competition. This limits consumer choice and brand variety, as firms cannot differentiate their products.

  4. Unrealistic assumptions

  The model assumes perfect information, no advertising, and no barriers to entry, which rarely exist in real markets. Because of this, Perfect Competition is often considered theoretical and not very applicable to real-world industries.

  5. Externalities are ignored

  The model does not account for external costs or benefits, meaning socially optimal outcomes may not occur if externalities exist.

characteristics of monopolistic competition

• monoposict copotetion is where there is many firms within the market. all with similare but diifrentiated products from there competitiors, so they are not equal substitutes. Therefore they are able to have limited price setting power. There product differentiate with branding, adverticement, atmosphere. There are low barreres to entry. e.g restaurants.

imperfect competition, differentiated products, low barriers to entry and exit, imperfect information, some degree of price setting power

Imperfect competition

There are many firms in the market, but they do not sell identical products, so competition is not perfect.

Product differentiation

Firms sell similar but differentiated products (e.g., branding, quality, packaging). This gives firms some control over price.

Low barriers to entry and exit

It is relatively easy for new firms to enter or leave the market, meaning firms can earn normal profit in the long run.

Imperfect information

Consumers and producers do not have full information, which allows firms to use branding and advertising to influence demand.

Some price-setting power

Because products are differentiated, firms are price makers to a limited extent and face a downward-sloping demand curve.

monopolistic competition analysis short run

firms profit maximise at MC=MR and they earn abnormal profts

Firms have price setting power, they are price maker till a certain extent, due to their differentiated products, causeing them to have a downwardsloping demand curve. Firms proift maximise untic MC = MR, therefore able to make abnormal (supernormal) profit as long as average revenue is greater than average costs.

monopolistic competition analysis long run

new firms enter the market and are attracted by the profits being made by the existing firms. this makes the demand for the existing firms' products more price elastic which shifts the AR curve to the left. consequently, only normal profits are made in the long run.

due to the low barriers to entry, new firms are attracted by the profit made from existing firms. As more firms try to join, the demand for existinf firms products will become more price elastic and therefor causing AR to the left. cause firms to only make normal profit in the LR where TR=TC

advantages of monopolistic competition

consumers get a wide variety of choice, the model is more realistic than perfect competition, abnormal profits in SR may promote dynamic efficiency

1. Greater consumer choice

Because firms sell differentiated products, consumers benefit from a wide variety of goods and services. Differences in quality, branding, packaging, and design allow consumers to choose products that best suit their preferences.

2. More realistic model than Perfect Competition

Perfect Competition assumes no advertising, perfect information, and homogeneous products, which rarely occur in real markets. Monopolistic Competition is more realistic because firms differentiate products and compete through advertising and branding, which reflects many real-world markets.

3. Potential for innovation and dynamic efficiency in the short run

Firms may earn abnormal (supernormal) profit in the short run. These profits can be reinvested into research and development, innovation, improved technology, branding, and product quality, increasing Dynamic Efficiency and potentially improving consumer welfare.

disadvantages of monopolistic competition

firms make normal profit - lack on dynamic efficiency in LR,

firms may have x-inefficiency since they have little incentive to minimise their costs - as firms face less intense competion compared to perf comp as they have differtiated products allowing them to have price setting power. - reducing the pressure to minimise costs - so they are less productivly efficitnt. - organisational slack and inefficient management.

, allocatively inefficient in SR and LR - Consumers are charged more than the cost of extra output. Some consumers who value the good more than its cost but less than the price are excluded from buying This creates a loss of potential trades, called deadweight loss - Definition: Resources allocated to maximize total welfare

Condition: Price (P) = Marginal Cost (MC) - In Monopolistic Competition, firms have some price-setting power due to product differentiation. As a result, price is greater than marginal cost, meaning Allocative Efficiency is not achieved in both the short run and long run.

productively inefficient since firms do not fully exploit their factors so there is excess capacity - Productively efficient - which goods and services are produced at the lowest possible cost, using all available resources fully and efficiently. Excess capacity = the firm could produce more using the same resources, without increasing average cost. Firms are not producing at the minimum AC point

They stop at MC = MR, which is not the lowest-cost output

characteristics of an oligopoly

high barriers to entry and exit, high concentration ratio, interdependence of firms, product differentiation

overt collusion

when firms explicitly agree to limit competition or raise prices e.g. a cartel. they do this using price fixing, setting output quotas which limit supply, agreements to block new firms from entering the market.

consequences of overt collusion

higher prices for consumers, less output in the market, poor quality products, less investment in innovation

tacit collusion

when firms avoid formal agreements but closely monitor each other's behaviour e.g. use of price leadership. firms monitor the price of the price leaders product and then adjust theirs to match

distinction between non-collusive and collusive oligopolies

collusive behaviour occurs when firms cooperate to fix prices and restrict output, the incentive to collude in oligopolies in high. non-collusive behaviour occurs when firms actively compete to maintain/increase market share e.g. price wars.

the kinked demand curve analysis

if a firm increases its price above p it is unlikely that rival firms will follow the price increase so the demand curve above p is price elastic.if a firm decreases its price below p it is likely that rival firms will follow so the demand curve below p is price inelastic, meaning total revenue and profit declines for all firms. the change in elasticities created price rigidity at the price level p as firms tend not to change price due to anticipated behaviour of competitors (mutual interdependence), so firms focus on non-price competition.

a cartel

a group of two or more firms which have agreed to control prices, limit output or prevent the entrance of new firms into the market e.g. OPEC which fixed their output of oil

price leadership

when one firm changes their prices and other firms follow. this firm is usually the dominant firm in the market. this explains why there is price stability in oligopolies, other firms risk losing their market share if they don't follow the price change.

price wars

a type of price competition, which involves firms constantly cutting their prices below that of its competitors, their competitors then lower their prices to match this e.g. the UK supermarket industry.

non-price competition

aims to increase the loyalty to a brand, which makes demand for a good more price inelastic

game theory

related to the concept of interdependence between firms in an oligopoly, it is used to predict the outcome of a decision made by one firm when it has incomplete information about the other firm e.g. prisoner's dilemma.

advantages of an oligopoly

significant abnormal profits can yield positive externalities and promote dynamic efficiency, higher profits could be a source of government revenue, industry standards could improve because firms can collaborate on technology and improve it, firms can exploit economies of scale.

disadvantages of an oligopoly

misallocation of resources compared to the outcome in a competitive market, if firms collude there is a loss of consumer welfare, collusion could reinforce monopoly power and the absence of competition could restrict efficiency.

charactistics of a monopoly

high barriers to entry, price makers, profit maximisers

monopoly diagram analysis

the firm is a price maker so the revenue curves are downward sloping and there is no differentiation between the firm and the industry. firms produce at the profit maximising level where MC=MR, the firm is making supernormal profits at this level

advantages of a monopoly

abnormal profits could promote dynamic efficiency, market power enables the firm to increase global competitiveness, increase in producer surplus, price discrimination could allow cross subsidation, economies of scale, abnormal profits could allow higher wages fro employees

disadvantages of a monopoly

due to lack of competition there is reduced incentive to be efficient, misallocation of resources because P > MC, innovation sometimes lacks effectiveness due to lack of competition, higher prices because there are no substitute goods, mo incentive to innovate, consumer surplus decreases, abnormal profits could go to shareholders

third degree price discrimination

when a firm charges a different price for the same good/service in order to maximise its revenue.

first degree price discrimination

when a firm separates consumers based on their ability to pay e.g. blind auction. this is known as 'perfect discrimination' but is unlikely to occur because it requires perfect information in the market

second degree price discrimination

when a firm gives discounts for bulk buying. often used to get rid of spare capacity to allow firms to pay fixed costs

conditions required for price discrimination

price making power, varying consumer price elasticity of demand, ability to prevent resale of tickets

third degree price discrimination diagram analysis

the overall firm is producing at the profit maximising level where MC=MR. the firm charges a higher price where demand is inelastic and a lower price where demand is elastic, so the total revenue has increased in each sub-market and the firm's total profits are higher than if they had charged a single price for all consumers.

advantages of price discrimination

consumers could benefit from a net welfare gain as a result of cross-subsidation if they recieve a lower price, producers make better use of spare capacity, the higher abnormal profits could stimulate investment and promote dynamic efficiency

disadvantages of price discrimination

loss of consumer surplus, since P >MC there is a loss of allocative efficiency, strengthens the monopoly power of firms which could lead to higher prices in the LR, if used as a predatory pricing method then firms could face investigation by the CMA, may cost firms to divide the market which limits the benefits they could gain

the process of creative destruction

If firms have monopoly power and they are making large profits, new firms have an incentive to enter the market and innovate, to overcome barriers to entry. This process of creative destruction is a fundamental feature of the way competition operates in a market economy. The process of creative destruction is linked to technological change and could lead to more innovation.

characteristics of contestable markets

no barriers to entry or exit, no competitive disadvantages on entry, perfect information, hit-and-run competition exists

hit-and-run competition

firms are attracted by the SR abnormal profits and once they have acquired these profits, they exit the market just as quickly

sunk costs

sunk cost is an investment that has been made that cannot be recovered. the lower the sunk costs, the more contestable the market