unit 5 market structures

allocative efficiency

• where recourses follow consumer demand, where society surplus is maximised, where net social benefit is maximised

• AR/P = MC

• MSB = MSC

• consumer benefit

  • resources follow consumer demand

  • low prices

  • maximisation of consumer surplus

  • high choice

  • high quality

• producer benefit

  • retained/increased MS

  • more competitive

  • increased profit

productive efficiency

• firm operating at the lowest point on AC curve - minimising costs, maximisation of output at the lowest AC

  • fully exploiting EOS

• MC = AC

• consumer benefit

  • lower prices

  • higher consumer surplus

• producer benefit

  • more production at lower cost - greater profit

  • lower prices - more competitive - greater MS

X efficiency

• minimising waste, producing on AC curve

• consumer benefit

  • lower prices - higher consumer surplus

• producer benefit

  • lower costs

  • higher profit

  • more competitive, higher MS

• X inefficiency = producing above AC curve

  • why

  • monopolist - no competition

  • public sector - not profit motivated, they maximise social welfare

dynamic efficiency

• reinvestment of long run supernormal profit back into the business in the form of better capital, R And D , innovation, new technology

• MR = MC (supernormal profit in the long run)

• consumer benefit

  • new products

  • lower prices over time because of new technology, production techniques more competition

  • high consumer surplus

• producer benefit

  • long run profit maximisation

  • more competitive - price maker ability

  • lower costs over time

static efficiency

• consist of these efficiency as they all occur at a specific production point, where as dynamic efficiency occurs over time

• allocative efficiency

• productive efficiency

• X efficiency

profit maximisation - objective of firms

• MR= MC - no more extra profit can be made

• why

  • reinvestment - innovation - lower costs

  • dividends for shareholders

  • lower costs and lower prices for consumers

• why do some firms not profit maximise

  • don’t know MR/MC

  • avoid regulation/investigation

  • key stakeholders harmed - consumers, workers, government - environmental groups (anyone with interest in business)

  • other objectives

profit satisficing - objective of firms

• anywhere between profit max and sales mx

• a firm sacrifices profit to satisfy as many key stakeholders as possible

• harming workers could cause a strike

• harming consumers could create bad publicity

• harming government could investigate

revenue maximisation - objective of firms

• MR = 0

• why

  • EOS benefits - higher quantity than profit max

  • predatory pricing - lower than profit max price

  • principle agent problem - divorce between ownership and control

predatory pricing

pricing strategy where a firm sets prices low, sacrificing profit with the intent to eliminate competition and gain market power

divorce between ownership and control

• a situation in which the owners of a firm (shareholders) are different from the managers (agents) who run the company, potentially leading to conflicts of interest

• owners want profit maximisation

• managers want to revenue maximise to inflate bonuses

sales maximisation - objective of firms

• growth maximisation

• AC = AR

• why

  • EOS - higher output

  • limit pricing - normal profit - no incentive for firms to enter market

  • principle agent problem - divorce between ownership an control

  • flood the market - increase brand loyalty

other objectives of firms

• survival - short term to enter a competitive market

• public sector organisation

  • P = MC, allocative efficiency

  • maximise society welfare

• corporate social responsibility

  • charity, sustainability, ethical

shutdown condition in perfect competition

• a business needs to make at least normal profit in the long run to justify remaining in an industry

• a firm will choose to operate if AR covers AVC, if AR falls below this level, the firm should shut down to minimize losses

• shutdown condition = AR =< AVC

  • this loss can no be sustained so it makes since for the firm to leave the industry and move FOP elsewhere

process innovation

changes in the way in which production takes place or is organised

product innovation

small scale and frequent subtle changes to the characteristics and performance of a good or service

perfect competition characteristics

• no barriers to entry / exit

• many buyers and sellers

• homogenous goods

  • price takers

• perfect information

• firms are profit maximisers

perfect competition in the short run

• price is determined by the market as firms are price takers (S = D)

• supernormal profit is made as AC is below AR

• profit is greater than costs

perfect competition in the long run

• the supernormal profit made in the short run attracts new entrants into the market (signal), and due to no barriers to entry and perfect information they can enter easily

• as these new firms enter the market, the market supply shifts to the right, lowering the price from P1 to P2

• firms take this new price as they are price takers meaning that now AR = AC reducing supernormal profit down to normal profit

perfect competition evaluation

• is allocatively efficient as AR/P = MC

  • highest consumer surplus

  • resources perfectly following consumer demand

• is productively efficient, operating at lowest point on AC curve (MC = AC)

• is X efficient as they are producing on the AC curve

• is statically efficient

• not dynamically efficient in the long run as there is no supernormal profit to reinvest

characteristics of monopolistic competition

• many buyers and sellers

• each firm selling slightly differentiated goods

  • price makers slightly

  • because of substitutes

  • so price elastic demand curves

• low barriers to entry / exit

• good information

• non-price completion as firms cant raise price too much

• firms are profit maximisers

• example - clothing market, restaurants

monopolistic competition in the short run

• firms are able to make supernormal profit in the short run as they exploit their price making power as they are selling a unique good

monopolistic competition in the long run

• in the long run firms enter the market as they are attracted to the supernormal profit (signal), they can do do as there are low barriers to entry and good information of market conditions

• this erodes away the supernormal profit made in the short run as new firms compete with established firms

• as new firms enter the market, demand for individual firms shifts left as consumers are shared across a larger number of new firms, consumers buy substitutes from new firms, while AC doesn’t move

• demand now = AC and supernormal profit is made

monopolistic competition evaluation

• allocatively inefficient in the long run as price doesn’t equal MR, price is greater that MC, consumers are exploited, restricted output, less choice

  • however not as bad as a monopoly as firms don’t have as much price setting ability as there is lots of competition, loss of consumer surplus isn’t as bad as a monopoly

  • compered to perfect competition, allocative inefficiency can be considered desirable as there are not homogenous goods, consumers are willing to pay more and erode a bit of their consumer surplus for that

• productively inefficient - voluntarily forgoing EOS and costs are not being minimised, producing a range of products makes it harder to achieve purchasing and technical EOS

  • more EOS than in perfect competition, so prices may be lower

  • productive inefficiency may be due to the product differentiation demand of consumers

• not dynamically efficient as there is no long run supernormal profit being made - cant be reinvested

  • however if short run supernormal profit is enough to reinvest we see dynamic efficiency

characteristics of an oligopoly

• few firms dominate the market

  • high concentration ratio

• differentiated goods

  • firms are price makers

• high barriers to entry / exit

• interdependence - firms don’t make decisions on their own - they make them off of actions/reactions of rival firms

  • price rigidity

• non-price competition

• profit maximisation is not the sole objective

examples of non-price competition

• product differentiation

• branding

• advertising

• quality of product / service

• example - UK supermarket industry

oligopoly kinked demand curve

• firms don’t want to change their price - price rigidity

• above P1 demand is price elastic

• below P1 demand is inelastic

• if a firms raises their price above P1, QD falls proportionality more that the increase in price

  • why, interdependence, other firms want to gain MS so keep their price at P1 and undercut this firm

  • so the firm that raised their price suffers and MS and total revenue decreases

• if a firm reduces price, demand increases proportionally less than the decrease in price as PED is inelastic

  • other firms follow the price decrease to retain MS and possibly get into a price war

  • total revenue falls and overtime there will be no change in MS

• as long as costs change within the vertical part of MR and the firm is a profit maximises (producing where MC = MR), they are going to be charging P1

  • as long as quantity is Q1, price is P1

oligopoly evalutation

• could be price competition in order to gain MS (price war)

• lots of non-price competition as prices stay rigid at P1, to attract consumers

• temptation to collude allows firms to act like a monopoly, fix prices and make supernormal profit

concentration ratio

• A measure of the market share held by the largest firms in an industry, indicating the level of competition

• used to assess market power

• CR4 = combined market share (sales) of the 4 largest firms

predatory pricing

• focuses on eliminating existing competitors

• prices are deliberately and temporarily set very low to restrict competition

• P < AVC, shutdown point

• illegal

limit pricing

• preventing potential competitors from entering market

• incumbent firms set price at AR = AC removing supernormal profit to remove the incentive for new firms to enter the market

collusion

• anti-competitive agreement between rivals that attempts to disrupt the markets equilibrium

• occurs when firms collaborate to set prices or output levels in order to maximize joint profits and reduce competition

• illegal

cartel

• group of firms that decide to cooperate and collude with each other

• illegal

factors promoting a competitive oligopoly

• large number of firms - harder to organise collusions

• new market entry is possible - making high profit from collusion incentivises entry to the market, taking away supernormal profit

• one firm with significant cost advantages - makes it hard to fix prices or quantity

• homogenous goods - firms don’t have price making power

• saturated market - only way to get ahead of firms is to take MS, high incentive to cheat on collusion

factors promoting a collusive oligopoly

• small number of firms - easier to organise collusive agreements

• similar costs - easy to fix prices and quantity

• high entry barriers - the supernormal profits being made from collusion wont attract new entrants

• ineffective competition policy - easier to get away with it

• consumer loyalty - firms wont cheat on collusion if other firms have loyal customers

• consumer inertia - consumers aren’t willing to switch suppliers

competitive oligopoly evaluation

• allocative efficiency

• X efficiency

• productive efficiency

• however no dynamic efficiency or EOS

collusive oligopoly evaluation

• dynamic efficiency - supernormal profit - profit max point

• not allocatively efficient

• not productively efficient

• not X efficient

• EOS benefits

overt collusion

open and formal agreements, is when cartels formally arrange to collude with each other

tacit collusion

• competitors coordinate their actions without explicitly agreeing to do so

• more difficult for the CMA to prove

• price leadership - firms copy the behaviour off the leading (dominant) oligopolist

price fixing in an oligopoly diagram

• in the industry firms are profit maximising producing where MC =MR, resulting in P1, Q1

• P1 take P1 as they are price takers

• the cartel member accepts the output quota other the price charged by the cartel will be distorted

• the results in supernormal profit for the cartel

• is a cartel cheats (incentive) and exceeds the quota, they will earn excessive supernormal profit, producing at the cheating quantity - P1 still covers AC

• however cheating cartel quantity = oversupply, threatening the stability of the cartel

• for the cartel to be success is for every member to keep price at P1

example of anti competitive behavior

in 2015 apple was fined 450 for conspiring with 5 publishers to increase e-book prices

real world advantages of oligopolies

• price stability - firms often avoid price wars, leading to more stable prices for consumers

• economies of scale - large firms can produce goods more efficiently, reducing costs and potentially lowering prices.

• innovation and r&d - competition among few large firms can drive significant investment in research, leading to better products and services

• consumer choice - despite few firms, product differentiation (e.g., branding, features) can offer consumers various options

real world disadvantages of oligopolies

• collusion risk - firms might collude (tacitly or overtly), fixing prices or output, which harms consumers

• restricted competition - new firms face high barriers to entry, reducing market dynamism and innovation over time

• higher prices - lack of genuine competition can keep prices artificially high compared to more competitive markets

• inefficiency - without competitive pressure, firms may become complacent, leading to productive and allocative inefficiency

• manipulative marketing - heavy focus on advertising and brand loyalty can lead consumers to make irrational decisions

issues with cartel

• enforcement problems - each firm finds it profitable to raise its own production - difficult for the cartel to enforce output quotas

• successful entry of a non-cartel firm - undercut a cartel price and control the market

• risk of severe penalties

cos of collusive behaviour

• damage to consumer welfare

  • higher prices, lost consumer surplus

  • loss of allocative efficiency

  • hits lower income households

• lack of competition

  • no incentive for X efficiency

  • no incentive to innovate - dynamic inefficiency

• reenforces cartels monopoly power

  • harder for new businesses to enter market

  • reduces contestability

characteristics of a monopoly

• one seller

• unique product

• high barriers to entry

• imperfect information

• price makers

• profit maximisers

• supernormal profit

different barriers to entry

• EOS

• brand loyalty

• patent

• geographical barriers

legal monopoly

firm has more than 25% market share

pure monoply

single seller in the market

natural monopoly

in order to reach productive efficiency, its better for production to be dominated by a single firm

monopoly graph

• the firm is a profit maximiser meaning it produces at MR = MC (Q1, P1), price is read from AR

• at Q1 AC is below P1, the difference between them is the unit level of supernormal profit, multiplied by the quantity gives us the total supernormal profit

efficiencies in a monopoly

• not allocatively efficient as they are not producing at AR/P = MC

  • misallocation of recourses, exploiting consumers with high prices, restricted output an low consumer surplus, choice and quality also low as there are no competitors

• not productively efficient as the monopoly is not producing where MC = AC

  • monopolist could also be too big casing diseconomies of sale, producing on the rising part of AC

• not X efficient as as they are producing above their AC curve allowing for waste because there is no competitive drive

• statically inefficient

• potential for dynamic efficiency as there are long run supernormal profits being made in the long term as there are high barriers to entry and imperfect information keeping other firms out the market

  • profits reinvested in innovation and new technology, capital investment

  • benefits consumers

monopoly deadweight welfare loss

• PM, QM is taken from the monopolies profit maximising point

• PC, QC is a competitive firms quantity taken from the allocatively efficient point of production

• monopoly reduces consumer surplus from ABC TO A

• monopoly increases producer surplus from DE to DB

• monopoly reduces society surplus (producer + consumer surplus) from ABCDE TO ABD

advantages of monopolies

• dynamic efficiency

  • reinvesting profit can result in better quality for consumers and possibly lower prices

• greater EOS

  • exploit greater EOS than competitive markets due to their size

• natural monopoly

  • a regulated natural monopoly can give society desirable outcomes and stop the wasteful duplication of resources

• cross substitution

  • use supernormal profits to subsidies a loss making good they are producing, socially desirable

disadvantages of monopolies

• allocative inefficiency, price is higher than marginal cost meaning consumers are exploited, paying more than what it costs to produce, lower consumer surplus

  • deadweight welfare loss of consumer surplus show on diagram

• productive inefficiency

  • voluntarily forgoes EOS by not operating where MC = AC, lower part of AC curve

• X inefficiency

  • allow waste in the production process due to a lack of competitive drive, producing beyond the AC curve

• can cause inequalities

  • especially in necessity markets

  • as prices are higher at MR = MC

monopoly evaluation

• supernormal profit may not be reinvested - dynamic inefficiency

  • profits may be given to shareholders as dividends, or pay debts

• EOS or DOS depending on size of the firm

• regulated monopoly can reduce inefficiencies

• price discrimination can exaggerate monopoly inefficiencies and inequalities

• competition threat can reduce inefficiencies

• type of goods or service

  • if good is a necessity it is bad however is the monopoly is producing a luxury good it may not be as harmful

price discrimination

where a firm charges different prices to different consumers for an identical good/service with no differences in cost of production

conditions for price discrimination

• price making ability - need monopoly power

• information to sperate the market into different PEDs

• prevent re-sale, stop people buying low and selling high (market seepage)

1st degree price discrimination

• consumers are charged the exact price they are willing to pay for a good/service

• eroding all consumer surplus and turning it into monopoly profit

2nd degree price discrimination

• firms with fixed capacity

• last minute, firms lower their prices in order to fill capacity and contribute towards fixed costs

  • airline company

• MC curve is horizontal (constant) up to their capacity where it becomes vertical where they cant produce anything more

• firm produces at MR = MC (Q1) maximising profits

  • results in excess capacity from Q1 to Qcap

• firm lowers price to fill capacity to bring in revenue to contribute towards fixed costs (P2), all capacity is filled

• consumers that buy last minute tickets gain consumer surplus

3rd degree price discimination

• occurs when a firm can segment the market into different PEDs

• based on time, age, geography or income differences and will charge different prices to different groups

• rail company

  • inelastic, people who need to get to work

  • elastic, leisure travellers, off peek times

• MC is constant as it costs the same to fill 1 more seat on the train

• higher prices in an inelastic demand, exploiting consumers

advantages of price discrimination

• greater profits can result in dynamic efficiency

• higher quantity in 2nd and 3rd degree allows for greater EOS - lower prices

• some consumers benefit for price discrimination

• cross subsidisation - profits may be used to subsidies loss making goods elsewhere in the business allowing them to still be provided to consumers

disadvantages of price discrimination

• allocative inefficiency

  • prices higher than MC, exploiting consumers

• inequalities

  • widens income inequality

• anti-competitive pricing

  • lower prices diving out competitors, pure monopoly power

characteristics of natural monopolies

• high fixed/sunk costs

• high potential for EOS

• rational for 1 firm to supply the entire market

  • to avoid the wasteful duplication of resources and non exploitation of full EOS - allocative and productive inefficiency

  • competition is undesirable

• examples - water, gas distribution

natural monopoly graph

• producing at the profit maximising point of MR = MC, Q1, P1 generates supernormal profit as P1 is above LRAC

  • high prices and low quantitates

  • bad outcomes for essential services such as water (excluding poorer consumers), compared to the allocatively efficient point (P = MC)

• charging these excessively high prices is deemed not good enough by regulators

• with regulation at the allocatively efficient point, means a reduction in price and costs to P2, C2

  • here there is subnormal profit being made as costs are now high than prices

• this incentivises to the natural monopoly to leave the industry, and so private natural monopolies are often subsidised

  • subsidy given is equivalent to to the loss per unit (a, b per unit) allowing them to make normal profit

natural monopoly evauation

• as long as the market is dominated by 1 firm and there is regulation, there is allocative (P=MC) and productive efficiency (lowest point on AC)

  • better outcome that a competitive market

• if regulated, there will be no more supernormal profit so dynamic efficiency isn’t possible

characteristics of a contestable market

• low barriers to entry/exit

• large pool of potential entrants

• good information

• incumbent firms (already in the market) subject to hit and run competition

  • firms quickly enter the market, take supernormal profit then leave again before incumbent firms can lower profit margins

how has technology increased barriers to entry

• decreased barriers to entry

  • lower sunk costs, easier to achieve EOS, easier to advertise

• increased pool of potential applicants

  • easier to innovate

  • cheaper ways of producing things

• improved information

contestability in a monopoly

• a monopoly prices at PM, QM, the profit maximising point, making supernormal profit

• if the market is contestable the monopoly would move to PC, QC where AR = AC the limit price, making normal profit, break even point, removing the incentive for firms to enter the market

• this lowers the price and increases the quantity - competitive outcome

• limits threat

• then price can be increased when the threat goes away

advantages of contestable markets

• movements towards competitive outcomes give similar benefits to a competitive markets

• allocative efficiency

  • lower price, higher quality, more consumer surplus, better choice

• productive efficiency

  • better exploitation of EOS, lower costs, lower prices for consumers

• x efficiency

  • minimising waste, lower costs, lower prices for consumers

• job creation because of higher quantity - labour is in derived demand

disadvantages of contestable markets

• lack of dynamic efficiency

  • lower profit margins, less progress over time

  • however if new firms come into the market with innovative ideas, that is the benefit of dynamic efficiency

• cost cutting in dangerous areas

  • safety, environment impacted

• creative destruction

  • new innovation destroys existing firms - job losses

  • however overall if market is greater workers who have lost jobs can move to newer firms

• anti-competitive strategies

  • overtime if businesses use anti-competitive strategies like limit or predatory pricing, flooding the market or mergers, contestability will not last overtime

  • results in static inefficiencies in long run

contestable markets evauation

• length of contestability

  • if new firms can patent ideas or use anti-competitive strategies, the market wont be contestable overtime

• role of technology

  • patents

  • makes it easier for firms to price discriminate as they have access to more information - not statically efficient

• regulation

  • minimise cost cutting in dangerous areas and anti-competitive strategies

  • negates other disadvantages

• dynamic efficiency