Chapter 4 - Market Structure

Perfect Competition

• In real life, there is no such thing as a perfectly competitive market as it is only an economics theory

• A perfectly competitive market follows these characteristics:

  • There is infinite number of suppliers and consumers

  • No firm has ‘market power’ therefore firms in a perfectly competitive market are price takers not price makers

  • Consumers and producers have perfect information

  • Products are homogeneous (identical)

  • There are no barriers to entry or to exit

  • Firms are profit maximisers

• Perfect competition leads to allocative efficiency because:

  • In a perfectly competitive market rationing, signalling and incentives work perfectly 

  • All firms are price takers which means the market sets the price according to consumers preferences, rationing resources and signalling priorities

  • Consumers and producers have perfect knowledge of the market, and therefore can change their output level based on incentives

  • In perfect competition, a market’s demand curve is equal to marginal unity because the consumers demand reflects what that good is worth to them which decreases as quantity increases due to the law of diminishing marginal utility

  • Allocative efficiency occurs when a goods price is equal to what consumers want to pay for it, and this happens because the price mechanism ensures that producers supply exactly what consumers demand

• In perfect competition, no firm makes supernormal profit in the long run as more firms enter the market, and therefore supernormal profits are competed away 

• In perfect competition, firms are productively efficient as they are trying to maximise profit and by doing so they will try to ensure that cost of production is as low as possible

• Firms will also try and keep X-inefficiency as low as possible as they are competing with other firms

• In perfect competition, dynamic efficiency cannot be achieved as this will include investing into research and development and as firms produce at normal profit, they cannot afford these investments

Monopolies 

• A monopoly is a market with only one firm in it or in other words a single firm has 100% of the market share

• Monopolies or firms with monopoly power can control the price

• Monopolies can form because of:

  • There are barriers to enter the market therefore profits are harder to be competed away

  • Consumers may think that a certain firms product is more desirable than other firms due to advertisement and product differentiation

  • There are few competitors in the market

• A monopolist makes supernormal profit, and as no new firms enter the market, profits are not competed away in the long term

• Monopolies do not produce goods at MC = AC, which is the lowest point of the AC curve, therefore they are not being productively efficient

• Firms also charge much higher prices that marginal cost which means they are not allocatively efficient and are being ‘over-rewarded’ for the products they are providing

Oligopolies

• Some industries are dominated by just a few firms, even though they have many firms in that industry overall. These are called concentrated markets

• An oligopoly is a market that is dominated by just a few firms, has high barriers to entry and which firms offer differentiated products

• Firms in an oligopoly are interdependent (the actions of one firm will affect the other firms in one way) and use competitive or collusive strategies to make interdependence work in their favour

• Oligopolies can either compete or collude, which means unlike in perfect competition there is no single strategy a firm can adapt to maximise profits

• Competitive behaviour is when various firms compete with each other, primarily on price

• Collusive behaviour is when various firms cooperate with each other, primarily on what price to charge

• Formal collusion involves an agreement between the firm, which is normally illegal

• Informal collusion happens when there is no agreement, but each firm knows it is in their best interest not to compete

• Competitive behaviour normally happens when one firm has lower costs than the others, when there's a relatively large number of big firms in the market, if the firms produce products that are very similar or if barriers to entry are relatively low

• Collusive behaviour normally occurs when the firms have similar costs, there are few firms in the market, there is a sense of brand loyalty and barriers to entry are relatively high

• The kinked demand curve explains price stability 

• If a firm increases its price in an oligopoly, they will see a big decrease in the demand for their product as consumers will switch to their competitors. In other words when price is increased, demand is price elastic, and if any firm raises its price it will lose out

• If a firm lowers its price, they will not gain any market share due to all the other firms also dropping their prices, so in other words when price is decreased, demand is price inelastic and any firm that lowers their price will lose out as they wont gain market share but the average price of their product will fall