Different Market strcutres

Characteristics of market structures

• Number of buyers and sellers

• Nature of the product

• Nature of information

• Barriers to entry and exit

Perfect information

When consumers and producers are aware of all market prices and the benefits/costs of goods and services and production

Imperfect information

When perfect knowledge is not known to help firms and consumers make optimal decisions

Asymmetrical information

When one party has more information than the other

Characteristics of perfect competition

- Many buyers and sellers
- Homogenous products (Price takers)
- Perfect information
- No barriers to entry/exit

Price taker

When the firm has to take the price set by the market

Perfect competition long run equilibrium

- AR = MR because the firm will always sell at one price regardless of how much it produces
- Since AR = MC, the firm is said to be allocatively efficient
- Since the firm is producing at the lowest point on their AC curve, they are said to be productively efficient
- Economic profit = 0, so firms earns normal profit

Profit maximising equation

MR = MC

Perfect competition short run supernormal profit

- If market demand reduced, the market demand curve would shift to the left, shifting AR upwards
- Economic profit > 0, so the firm would be earning supernormal profit
- It would no longer be operating at the lowest possible cost therefore it would be productively inefficient
- Since AR = MC, it would be allocatively efficient

Perfect competition returning to long run equilibrium after earning supernormal profit

As a result of the supernormal profit, more firms will enter the market, shifting the market supply curve to the right, back to equilibrium. The new firms will erode the supernormal profit until firms are earning normal profit.

Perfect competition short run subnormal profit

- If market demand reduced, the market demand curve would shift to the left, shifting AR downwards.
- Economic profit < 0, so the firm would be earning subnormal profit
- The firm would be productively inefficient as it wouldn't be producing at the lowest possible cost
- Since AR = MC, it would be allocatively efficient

Perfect competition returning to long run equilibrium after earning subnormal profit

Due to the subnormal profit, firms will begin to exit the market, shifting the market supply curve to the left, back to equilibrium. As firms leave the industry and price rises, the level of loss reduces until the firm earns normal profit.

Are supernormal and subnormal profits sustainable in the long run?

No, except in a monopoly

Characteristics of monopolistic competition

- Imperfect competition
- Slightly differentiated products (Price makers)
- Many buyers and sellers
- Imperfect information
- Low barriers to entry and exit

Monopolistic competition long run equilibrium

- Demand curve (AR curve) is downward sloping as the firm can set the price
- MR curve twice as steep as AR curve
- AC is tangent to the AR curve
- AR ≠ MC so firm is allocatively inefficient
- Firm doesn't produce at the lowest possible cost, so it's productively inefficient
- Economic profit = 0, so firm earns normal profit

Monopolistic competition short run supernormal profit equilibrium

- AR and MR same as in long run equilibrium
- Profit maximising output level results in a price that is higher than AC
- Economic profit > 0, so the firm earns supernormal profit

Monopolistic competition returning to long run equilibrium after earning supernormal profit

- Firms enter the market as a result of supernormal profit
- As new firms enter the market, demand for this firm's product will fall as customers will take their business elsewhere
- AR curve will shift backwards until firm is earning normal profit

Characteristics of oligopoly

- Homogeneous or differentiated products
- A few large firms
- Price makers
- Interdependent, strategic behaviour

Concentration ratio

Combined market share of the top firms

Collusion

Occurs when firms manipulate a market to restrict output or raise prices in order to increase profits

Cartels

Groups of firms that collude together

Kinked demand curve model assumptions

- Firms are non-collusive
- Price rigidity (where prices remain the same despite changes in costs)
- The demand curve kinks at a specific price point

Constructing the kinked demand curve

- Draw inelastic and elastic demand curves along with the MR for each, respectively
- Set a price where the demand curves intersect
- Above the price take the elastic demand curve, and below the price, take the inelastic demand curve
- Add the MR curves for the elastic and inelastic demand curves respectively
- Finally add an MC curve at the profit maximising equation, MR = MC, preferably on the lower MR curve

Explain the kinked demand curve

- If the firm decides to raise the price, consumers will choose not to pay more for the product, as other firms haven't followed this price change, so they'll just buy from them
- If the firm decides to reduce the price, other firms will do the same out of fear of losing customers, preventing the firm from gaining a large portion of customers

Why wouldn't there be a change in output if costs were to rise?

If costs increased and MC shifted upwards, it would still satisfy the profit maximising equation MC = MR because of the kink

Tacit collusion

An informal type of collusion in which firms don't explicitly agree to collude

Price leadership

A form of tacit collusion in which one dominant firm sets a price and other firms follow

What must take place for price leadership to be mutually beneficial?

- The dominant firm must consider the responses of its rivals when setting prices
- The dominant firm may consider setting their price high enough for following firms to secure additional benefit

Formal collusion (ILLEGAL)

A form of collusion in which firms explicitly agree to collude

Pure monopoly

Firms that has 100% of market share

Monopoly (Competition and Markets Authority definition)

Controls more than 25% of the market

Characteristics of a monopoly

- One dominant seller
- Unique product (none or few close substitutes)
- High barriers to entry (Patents, trademarks, copyrights, advertising barriers, high sunk costs)
- Price makers
- Is able to maintain supernormal profits in the long run

Monopoly equilibrium

- Downward sloping demand curve (AR curve) as firm is price maker
- MR curve twice as steep
- MC curve as normal
- AC curve below price as there is supernormal profit being made
- Economic profit > 0, supernormal profit

Why does a monopoly make supernormal profits in the long run?

High barriers to entry and market power of the monopolist prevent new firms from entering the market and eroding the supernormal profits

Natural monopoly

Where, due to economies of scale, it's most efficient for there to be one firm in the market

Characteristic of natural monopoly

- High sunk costs
- Economies of scale at very high levels of output

Natural monopoly equilibrium

- LRAC and LRMC downward sloping as they reduce over time (EOS)
- Demand curve (AR curve) is downward sloping, price maker
- MR curve twice as steep

Regulated natural monopoly

- Firms originally produce at price of profit maximising equation, MC = MR and makes supernormal profit
- In order to maximise social welfare, government intervenes and sets price at allocatively efficient level where AR = MC
- At this price, natural monopoly is making subnormal profit, economic profit < 0
- Government subsidises the subnormal profit to the natural monopoly.
- Therefore, both allocative and productive efficiency are achieved as the firm is producing at its lowest possible cost and also where AR = MC

Examples of natural monopolies

Public utility providers (Electricity, gas, water, transport

Characteristics of perfectly contestable markets

- No sunk costs
- No barriers to entry or exit
- Possibility of 'hit and run competition'
- A pool of potential entrants exists
- No customer loyalty
- Perfect information

Hit and run competition

New competitors can enter and exit the market easily in pursuit of supernormal profit

Implications of contestability

- Firms will produce where AR = MC (Allocatively efficient)
- Firms will produce at the lowest point on the AC curve (Productively efficient)
- Normal profits earned

How can markets become more contestable?

If the government deregulates an industry, lower barriers to entry, greater actual and potential competition