IB Economics: 2.11

Characteristics of a market structure

- Market Power (price-controlling ability)

- Product differentiation

- Barriers to entry

TR

P x Q

MR

ΔTR / ΔQ

Explicit Cost

A payment made by a firm to an outsider to aquire an input.

Implicit Cost

The income sacrificed by a firm that uses a resource it owns (basically an opportunity cost)

Total Cost

Explicit + Implicit Costs

MC

ΔTC / ΔQ

Profit

TR - TC

AC

TC / Q

Normal Profit

TR = TC

Abnormal Profit

TR > TC

Loss / -ve Economic Profits

TR < TC

Characteristics of perfect competition

1. Large number of firms in the industry

2. All the firms sell a homogenous or identical product

3. No barriers to entry and exit to/from the industry.

Price-takers in perfect competition

Because there are many substitutes, the demand curve for a good in a perfectly-competitive market is perfectly inelastic.

This means the firm has no ability to influence the price, therefore has no market power.

Profit in the short run vs long run in perfect competition

In the short run, firms can make abnormal profits or losses. This changes the state of the market, as firms may enter or leave the market.

If firms leave the market (when making losses), the market supply reduces and prices increase. Firms make normal profits.

If firms enter the market (when making abnormal profits), the market supply increases and prices reduce. Firms make normal profits.

Therefore, in the long run, firms only make normal profits.

Benefits of perfect competition

Allocative Efficiency

Low prices for consumers

Competition leads to the closing down of inefficient producers

Market responds to consumer tastes

Criticisms of perfect competition

Unrealistic

Cannot take advantage of economies of scale

Lack of product variety

Limited ability to engage in new product development

Perfect Competition Graphs

Output and Price are MC = MR

AR = MR = D curve is perfectly elastic

MC intersects AC at its lowest point

Placement of AC curve above/below AR = MR curve gives profit type.

Characteristics of Monopoly

Single/dominant firm in the industry

A unique good/service is sold, with no close substitutes

High barriers to entry, which restricts other firms from entering the market.

Barriers to Entry

Natural Monopoly

Economies of scale

Branding

Legal Barriers (patents, licenses, copyrights, tariffs/quotas)

Control of essential resources

Aggressive tactics

Benefits of Monopoly

Economies of scale

Likely to engage in research development for product development and technological innovation

Criticisms of Monopoly

Welfare loss and allocative inefficiency

Higher price and lower output

Loss of consumer surplus

Negative impacts on the distribution of income

Lack of competition may result in higher costs and less product development

(No incentive to efficiency or innovation)

Monopoly Graphs

Output is when MC = MR

Price is read from that level of output but from AR curve

MC intersects AC at its lowest point

Placement of AC curve above/below AR = MR curve gives profit type.

Natural Monopoly

Operate in a market with high fixed costs (railways, telecom, utilities).

Lot of potential for economies of scale

Competition is undesirable because it is rational for one firm to supply the entire market. There will be duplication of resources and not exploitation of full economies of scale.

Natural Monopoly graph

LRAC curve is shaped like first half of economies of scale (because natural monopolies exploit economies of scale).

Characteristics of Monopolistic Competition

Fairly large number of small/medium-sized firms in the industry

Low barriers to entry

There is product differentiation

Product Differentiation in Monopolistic Competition

Physical differences

Quality differences

Services

Product image

Profit in the short run vs long run in monopolistic competitiion

In the short run, firms can make abnormal profits or losses. This changes the state of the market, as firms may enter or leave the market.

If firms leave the market (when making losses), the market supply reduces and prices increase. Firms make normal profits.

If firms enter the market (when making abnormal profits), the market supply increases and prices reduce. Firms make normal profits.

Therefore, in the long run, firms only make normal profits.

Monopolistic Competition Graphs

Output is when MC = MR

Price is read from that level of output but from AR curve

MC intersects AC at its lowest point

Placement of AC curve above/below AR = MR curve gives profit type.

AR and MR curves are less steep than monopoly in monopolistic competition due to higher elasticity. But they are not as steep as in perfect competition.

Characteristics of Oligopoly

Small number of large firms in the industry.

Firms are interdependent, so the actions of one affect the others.

Products may be either differentiated or not

Non-price competition

High barriers to entry

Interdependence in oligopoly

Can be used for strategic behaviour by making changes based on those of your competitors'

Conflicting incentives may result in collusion, competition/cheat.

Collusion

Agreement between firms to limit competition between them, usually by fixing price and lowering quantity produced.

Non-price competition

Product development

Advertising

Branding

Customer services

Warranty

Credit, discounts, upgrades, etc.

Game theory and nash equilibrium

Shows that there is sometimes a conflict between the pursuit of individual self-interest and the collective firm interest. This is the prisoner's dilemma. Although they could be better by cooperating, each firm, trying to make itself better off, ends up making both itself and its rival worse off.

Collusive Oligopoly

Firms agree to collude - to limit competition, increase market power and profits.

Cartel

Formal agreement to take actions to limit competition, increase market power and profits.

E.g. OPEC

There can be difficulties due to number of firms and cost differences that may lead to price wars.

Non-collusive oligopoly

Firms are independent but follow each others' actions strategically. However, no collusion may lead to price rigidity.

Collusive oligopoly graph

Benefits of Oligopoly

Economies of scale can be achieved due to the large size of the Product development and technological innovations can be pursued due to high abnormal profits

Product development leads to increased product variety.

Criticisms of Oligopoly

Allocative inefficiency

Negative impacts on distribution of income

Price rigidity

Collusion

Profit-maximizing level of output

MR = MC

Revenue Maximizing Level of Output

MR = 0

Allocative Efficiency

P = MC

or MC = AR

Productive Efficiency

MC = AC (lowest point on the AC Curve)