micro- competition policy (monopolies v. perfect competition)

define natural monopoly

• an industry structure where a single firm can supply the entire market at a lower average cost than two or more competing firms due to high fixed costs

explain why high fixed infrastructure costs makes single- firm supply more efficient

• industry requires large upfront sunk fixed costs (e.g. laying water pipes/ rail networks) before it can supply the product

• one firm can spread the fixed infrastructure cost over the largest possible number of consumers, driving unit costs down

• single- firm supply avoids wasteful duplication of capital, maximising productive efficiency for the market

what is a monopoly?

• a firm with over 25% market share

define productive efficiency

• occurs when production takes place at the lowest possible cost per unit, operating at the minimum point of the Short-Run or Long-Run Average Cost curve

define allocative efficiency

• occurs when resources are distributed to produce the combination of goods and services most desired by society

• achieved where price equals marginal cost (P = MC)

define dynamic efficiency

• improvements in productive efficiency and product quality over time

• achieved through continuous investment of supernormal profits into R&D, capital amelioration and innovation

define X- inefficiency

• a type of inefficiency that occurs when a firm lacks competitive pressure, causing its production costs to rise above the minimum achievable average cost curve

explain why greater competition leads to lower prices

• to survive and gain market share, firms are forced to reduce waste and streamline production

• achieving productive effiiciency

• lower average costs allow firms to lower prices without sacrificing profitability to attract consumers

• consumers pay lower prices and buy more

• therefore, consumer surplus and welfare increase

explain why competition improves quality

• firms risk losing customers

• they improve quality and customer service

• consumers receive better products

• welfare increases

explain how competition improves efficiency

• firms face pressure from rivals

• firms minimise waste and production costs to remain competitive

• this lowers average costs (productive efficiency)

• firms must align output with consumer demand to prevent losing market share to rivals

• therefore, resources are allocated more efficiently (allocative efficiency)

explain how competition promotes dynamic efficiency

• firms compete to gain a competitive advantage

• they invest in R&D and new capital

• this investment leads to innovative production processes or higher quality products

• over time, these innovations lower the firm’s LRAC, shifting the entire curve downwards

explain why monopolies may charge higher prices

• monopoly firms have significant market power

• consumers have few close substitutes

• the firm can restrict output

• scarcity allows higher prices, earning the firm supernormal profits

• consumers lose out as they pay more and get less, which reduces consumer surplus and welfare loss may arise

explain why monopolies may achieve lower average costs

• monopolies operate at a very high output level

• high output allows the firm to exploit economies of scale

• fixed costs are spread over a much larger quantity of output, and therefore LRAC fall significantly

• therefore, the firm achieves productive efficiency gains, allowing it to pass on lower prices to consumers

explain why monopolies may be dynamically efficient

• monopolies earn supernormal profits in the LR

• the firm reinvests some of this profit into R&D and new capital

• this investment leads to innovative production processes or higher quality products

• over time, these innovations lower the firm’s LRAC, shifting the entire curve downwards

explain how competition policy benefits consumers

• competition policy reduces market power

• more firms can enter the market

• increased competition puts downward pressure on prices

• consumers pay less and have greater choice

• therefore, consumer welfare increases

why is competition not always desirable?

• competition usually lowers prices and improves quality

• however, in natural monopolies, one firm can achieve lower average costs through economies of scale

• forcing competition may duplicate infrastructure and increase costs, creating productive inefficiency

• therefore, competition is not always the most efficient market structure

why might regulating a monopoly be better than increasing competition?

• competition may increase production costs in natural monopolies

• regulation can cap prices and prevent the abuse of market power while allowing the monopoly to retain its cost advantages

• preserves EoS while protecting consumers from excessive prices

why may lower prices not improve long- run welfare?

• intense price competition reduces profits

• firms invest less in R&D and capital

• innovation slows

• therefore, lower prices today may reduce consumer welfare in the future

why might a monopoly fail to pass on cost savings from EoS to consumers?

• instead of passing LRAC cost savings down to consumers via lower prices, the firm restricts output to charge higher prices

• the monopoly retains the cost savings as supernormal profits for shareholders

• resulting in allocative inefficiency and consumer exploitation

how does X- inefficiency stop a monopoly from achieving lower average costs?

• high barriers to entry protect the monopoly from market competition

• without competitive pressure, firms become complacent and organisational slack develops

• production costs drift upwards