3.4 Market Structures and 3.6 Govt Intervention
Allocative efficiency- value that consumers place on good or service = cost of resources used up in production.
price = marginal cost.
Productive efficiency- a business in a given market or industry reaches the lowest point of its average cost curve.
Output is being produced at minimum cost per unit - efficient use of scarce resources, high level of factor
productivity
Dynamic efficiency- occurs over time- focuses on changes in the consumer choice available in a market together with
the quality/performance of goods and services that we buy
Pereto efficiency- Where it is not possible for individuals, households, or firms to bargain or trade in such a way that
everyone is at least as well off as they were before and at least one person is better off..
Static efficiency- measures how much output can be produced from given resources and whether producers charge a
price that reflects fairly the cost of the factors used to produce a product
X-inefficiency- a lack of competition may give a monopolist less incentive to invest in ideas. The actual unit cost of
production is higher than cost we may see in competitive market
R&D- spending by businesses towards the innovation, introduction and improvement of products and processes.
greater dynamic efficiency
Perfect competition- where prices reflect complete mobility of resources and freedom of entry and exit, full access to
information by all participants, homogenous products, and the fact that no one buyer and seller has an adv
Price taker- when a firm take the ruling market price as its demand curve-
Monopolistic competition- competition between companies whose products are similar but differentiated to allow
each to benefit from monopoly pricing- demand is not perfectly elastic
Non price competition- competing not on the basis on price but quality, product, packaging, service
Price maker- a business with price setting power- imperfectly competitive markets
Product differentiation- when a business seeks to distinguish what are essentially the same products by real or
illusory means
Marginal profit- the increase in profit when one more unit is sold or difference between MR and MC
Monopoly profit- firm is said to reap monopoly profits when a lack of viable market competition allows it to set its
prices above equilibrium without losing profits to competitors
Normal profit- minimum amount of profit required to keep factors of production in their current use. AC not MC
Supernormal profit- A firm earns supernormal profit when its profit is above that required to keep the resources in
their present use in the l/r i.e. when price > average cost (AR>AC)
Shut down price- in the s/r firms will continue to produce as long as total revenue covers TVC P>AVC
Barriers to entry- obstacles for firms entering a market
Bi-lateral monopoly- situation where there’s a single or few buyer(s) and seller(s) of a given product in a market
Anti-competitive behaviour- strategies such as predatory pricing that are designed to limit the degree of competition
in a market
,Concentration ratio- measures the proportion of an industry’s output or employment by the largest firms. high =
monopoly, duopoly, oligopoly.
First mover advantage- business that creates a new product- first into the market- comp adv- learning by doing – more
difficult and costly for new firms to achieve profitable entry
Oligopoly- a market dominated by a few producers
Cartel- an association of businesses or countries that collude to influence production levels and thus the market price of
particular product(s)
Collusion – takes place when rival companies cooperate for their mutual benefit. 2 or more parties act together to
influence production and or prices level- preventing fair comp. common in oligopoly/ duopoly
Overt collusion – formal and open agreements between firms to undertake actions that are likely to minimise a
competitive response
Tacit collusion- when firms undertake actions that are likely to minimise a comp response- firms cooperate but nor
formally, secret, unspoken cooperation
Heterogenous products- products differentiated by design, packaging, functionality, performance
Interdependence- when the actions of one firm has an effect on competitors. A feature of oligopoly. When two or more
things depend on another
Kinked demand curve- assumes business might face a dual demand curve based on likely reactions of other firms in the
market to a change in its price or another variable
Late mover advantage- The advantage a company gains by being one of the later entrants to sell a product or provide a
service, when technology has improved and can be copied easily
Game theory- when there are 2 or more interacting decision takers and each decision or combination of decisions involves
particular outcome (knows as payoff)
Nash equilibrium- the outcome of a game that occurs is when player A takes the best possible action given action of player
B and player B takes the best possible action given action of player A
Prisoner dilemma- a problem in game theory that demonstrated why 2 people might not cooperate even if its in their best
interest to do so. No matter what the other player does, one will gain a greater payoff by playing defect
Pay off matrix- used in game theory- table to simplify all possible outcomes of strategic decision
Price war- vigorous comp between businesses often in s/t battle for MS and inc cash flow
Monopoly- A market structure characterised by a single seller, selling a unique product in the market.
Competitive tendering- system introduced in UK during 1980s to force publicly run organisations to request bids from a
number of different firms for contracts to supply goods or services.
§ Price regulation
§ Profit regulation
Monopsony - As a firm grows in size it can purchase its factor inputs in bulk at negotiated discounted prices- particularly
the case when a firm has monopsony (buying) power in the market
Natural monopoly -For a natural monopoly the long-run average cost range of output.
Sunk costs - cannot be recovered if a business decides to leave an industry
Second degree price discrimination
,Allocative efficiency occurs when P (AR) = MC. This is where demand = supply, maximising sum of both CS and PS,
feature of highly comp industry. At this point of point of production resources are allocated to consumer demand
with consumers what they demand at exact quantity they desire (society surplus is maximised). Consumer choice is
high and prices are low max CS. Quality is great and drive to meet needs and wants of consumers
§ Producers benefit from allocative efficient by getting ahead of rivals who aren’t meeting consumer needs and
increase MS- result in higher profits for business
Productive efficiency: occurs at lowest point of average cost curve, where MC=AC. Means full exploitation of EOS -
firms can’t increase output and lower AC further. These lower AC may = lower prices = CS increases
§ Producer- lower AC= higher levels of supernormal profits over time. Increases In MS- if EOS benefits translates
into lower prices than rivals
Dynamic efficiency-
Supernormal profit is being made in l/r. profit can be reinvested, tech adv, innovation, R&D. Hugely beneficial for
consumers – brand new, quality goods. Prices can lower over time, if COP are reduced,
§ Producers= LR profit max= lower costs over time- retain/ inc ms product development, monopoly power esp if
products are patented increasing profit making potential. Products can increase MS-crucial in comp industry
ahead of rivals. Tech can reduce costs of production – more profitable
X- efficiency producing on average cost curve at any given quantity level.
Firms are minimising their unit costs at a given production point, no waste in production. Highly comp firms, x-
efficient = crucial to charge lowest prices for consumers= CS inc
§ Producers= lower average costs= higher level of supernormal profits. Increase in MS= lower prices charged
compared to rival firms
X-inefficiency: If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is
organisational slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their
cost for that specific output. Not producing on the lowest AC curve. It often occurs where there is a lack of
competition so firms have little incentive to cut costs.
Static efficiency occurs at one given point of production at one specific point in time. Implying allocative, productive,
x-efficiency = statics. Dynamic occurs over time with condition that l/r supernormal profit is made which is
reinvested back into the company benefiting both consumers and producers at some point in the future
,Advantages to consumers of competition between firms
§ Greater competition incentivises firms to keep unit costs low in order to pass on the lowest possible price to
§ Lower prices for consumers.
§ Greater product range- product
§ Increases consumer surplus, SOL, material wellbeing.
§ Increase choice
Disadvantages:
§ Greater competition may actually
§ Not all firms may be able to compete
§ Disadvantages to consumers of competition between firms:
§ Quality issues – businesses using FOP unsustainable
§ Lack of innovation and R&D due to lack of profits
§ Negative externalities- pollution, resource depletion, degradation, in the l/r disadvantages consumers
Advantages to producers of greater competition:
§ Greater allocate efficiency- using resources more efficiently
§ Lower costs – high levels of supernormal profit – invested- diversification- dynamic efficiency
§ Economies of scale – lowers average unit costs
§ Market share inc
Low barriers to entry or exit- firms attracted
Disadvantages
§ Predatory pricing
§ Sunk costs- irretrievable costs if a firm is being outcompeted then all the money, they spent on adv and promo- can’t
get that back= bankruptcy
§ Follow suit? Businesses feel greater pressure – exploiting supply chain
§ Low BTE and exit- greater cop
,Market structure- characteristics of a market that determines firm behaviour
Perfect competition characteristics: high degree of competition
§ There are many infinite buyers and sellers in a perfectly competitive market. Concentration ration is 0 - firms
must compete with each other to survive in the marketplace. Demand for firm’s goods is perfectly elastic, and
prices are solely determined by interaction of demand and supply; the firms are price takers.
§ The goods and services produced are homogenous (identical). - PRICE TAKERS, taking price set by the market,
they have no influence at all in setting prices with no differentiation between products. If firms raised their price-
lose all their customers. If firms reduce price, either all firms would follow immediately reducing revenues or
revenues will not cover costs= losses that can’t be sustained
§ There are no barriers to entry or exit for firms, meaning entry and exit is completely costless. If firms are
attracted by supernormal profits- enter straight away and if firms want to leave due to losses being made, they
can do so immediately. This implies that s/r supernormal profit won’t be sustained in the l/r. L/r – normal profit
§ There is perfect information/ knowledge of market conditions for both consumers and producers. For consumers
= perfect information over prices being charged. Producers = perfect information over costs and technology as
well as prices being charged
§ Firms are profit maximisers producing where marginal cost= marginal revenue at all times and consumers are
utility maximisers consuming only up until price equals their marginal utility
Perfect competition- firm behaviour, short run supernormal profit
Examples:
§ Agriculture
§ Forex
The market equilibrium is at P1. Taking this price, firms will profit maximise where MC=MR producing Q2 units of
output. At this level of production, AR> AC, thus the firm is making supernormal profits indicated by the shaded
rectangle. Firms are attracted into the industry by the supernormal profits and with no barriers to entry, the supply
curve shifts to the right from S1 to S2 thus the market equilibrium price falls. This process continues from P1 to P2
until the demand (AR) curve; for an individual firm is tangential to the AC curve, where normal profit is being made
and the firms has returned to a long run stable equilibrium at Q4
§ Perfect competition is productively efficient (short run and long run profit), since they produce where MC=AC.
They are also allocative efficient in the long run since they produce where P=MC. Thus, they are static efficient.
§ However, they are not dynamic efficient . No single firm will have enough for research and development and
small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be
adopted by another firm and so the investment will give the firm no competitive benefit. Governments tend to
have to do all the research.
§ Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from
economies of scale and this may mean costs are higher than they otherwise could be.
,Perfect competition- firm behaviour, short run subnormal profit (loss)
Market equilibrium price is at P1.
Taking this price, firms will profit
maximise where MC = MR are
producing Q2 units of output. At this
level of production, AR < AC, thus firm
is making sub normal profit(economic
losses) indicated by shaded rectangle.
Firms who are not covering the AVC of production will shut down and leave the industry to minimise their losses
immediately given no barriers to exit = supply curve shifts to the left from S1 to S2 inc- market equilibrium price. This
process continues from P1 to P2 until the demand AR curve, for a firm is tangential to the AC=MC equilibrium -
normal profit is made and firm has returned to a long run stable equilibrium at Q4 long run equilibrium is perfectly
competitive market is defined by normal profit AR=AC and allocate efficiency where P= MC Q4
Perfect competition- Long run performance pros
1. Allocative efficiency is achieved in S/R and L/R. Firms in perfect competition produce where P=MC at the l/r
equilibrium. This is where demand= supply maximising the sum of both CS/ PS – key feature of a highly comp
industry. At this point, resources are allocated according to consumer demand - consumers getting what they
demand at exact quantity desire. Consumer choice is high & prices = low maximising CS in market. The quality of
the product being sold is excellent too given the drive to meet the needs and wants of the consumer
Producers benefit from being allocatively efficient getting ahead of rivals who are not meeting consumer wants and
needs= increasing their MS. Overtime = higher profits for business. Perfectly competitive firms must be allocatively
efficient otherwise they will lose market share to rivals who are doing so.
2. Productive efficiency is achieved in the long run. perfectly competitive firms produce at the lowest point of the
average cost curve, where MC=AC at the long run equilibrium point of production. This means all possible
economies of scale are being exploited as firms cannot increase output and lower their average costs any further.
These lower average costs can translate into lower prices for the consumer increasing their consumer surplus
Producer lower average costs- higher levels of supernormal profit over time and increases in market share if
economies of scale benefits translate into lower prices than rivals. Perfectly competitive firms must be allocatively
efficient otherwise they will lose market share to rivals who are doing so.
,Perfect competition- Long run performance cons
Dynamic efficiency isn’t being achieve in l/r. Supernormal profits aren’t being made in long run restricting firms
ability to reinvest back into business. Over times consumers don’t benefit with no tech advances of innovative new
products reducing choice and also preventing price falls in the future
§ For produces the profit making potential reduces without R&D - new product launches which could’ve been
patentable providing monopoly power. New products could’ve increase MS- crucial in comp industry.
Technology could’ve allowed cost of productions to be reduced and that’s become more profitable overtime
Product homogeneity is not in the best interest of consumers -prefer variety rather than having a large number of
different sellers all producing same good/ service. Allocative efficiency - not actually maximise benefit of consumers
With such intense competition and drive to reduce cost as much as possible to survive in long-term the actual
quality of output may not be as good as it could be- cost savings have to be made any where possible, might imply
poorer customer service and less focus on quality parts raise cost of production but provide consumers greater
satisfaction upon consumption
A perfectly competitive market can lead to creative destruction where supernormal profits attract new and more
efficient firms into industry new firms will drive out less efficient incumbent firms unable to complete. Whilst this is
good news for consumers who see regular price reductions over time due to efficiency gains existing firm shutting
down an increase in unemployment causing problems for the government this argument is weak however as the
benefits of competition with new efficient firms entering the market outweigh the cost. In a market economy losses
and shutting down must be accepted as much as profits and success
Perfect competition- long run performance evaluation
§ Static versus dynamic efficiency. Perfect competition deliver static efficiency; consumers benefits usually so do
producers where market share can rise. However dynamic efficiency is a big loss along with product
homogeneity. Consumers may be willing to lose some static efficiency benefits, instead paying slightly higher
prices in return for differentiated goods and innovative product development overtime
§ The notion that firms are always dynamically inefficient and highly competitive industry is due to lack of
supernormal profit in the long run may not hold in reality. Firms may be forced to reinvest whatever profits they
are making even normal profits to stay ahead of rivals and compete in such a fiercely competitive market. This
will be in the long-term interest of firms - element of monopoly power - can exploit to increase profit over time.
Perfect competition Evaluation/ criticism
§ Is it real? Most firms have some degree of price setting power
§ Highly complex products- information gaps facing consumers- live in a world of complex products
§ Homogenous products- patents, control of intellectual property, control of key inputs are all ignored by the
perfectly competitive model
§ Rare for entry and exit in an industry to be costless- very few industries that are perfectly contestable
§ Are firms really minimising costs if they cannot exploit E.O.S
§ Role for regulation
,Perfect competition – shutdown condition
Firms who are making enough revenue to cover their variable costs of production (AR>AVC) should continue
producing in the short run even when losses are being made in perfect competition.
• Continuing in production = reduce total losses whereas shutting down would result in greater- losses, thus
moving FOP to where they have better use is not yet the more beneficial option. By staying in production, other
firms who are not covering their variable costs leave the industry= increase the market price allowing remaining
firms to make at least normal profit or better, supernormal profits in the long run. In Figure 1, subnormal profits
are being made at the profit maximising level of output, Q1 as AR<AC, indicated by the shaded rectangle. As this
firm is covering its variable costs, AR is greater than AVC, it should continue to produce in the industry. This is
only true for a short period, as continual losses cannot be sustained in the long run. If losses persist, even firms
who are covering their average variable costs will eventually leave the industry.
• Firms who are not making enough revenue to cover their variable costs of production (AR<AVC) will shutdown
when losses are being made in perfect competition. This is because continuing in production will increase total
losses whereas shutting down would result in lower losses, thus moving factors of production to where they have
better use is a more beneficial option.
• In Figure 2, subnormal profits are being made at the profit maximising level of output, Q1 as AR<AC, indicated by
the shaded rectangle. As this firm is not covering its variable costs, AR is also less than AVC, it should shutdown
and leave the industry.
Loss if shutdown – look at TFC Shutdown condition: AR=AVC
Loss if continue- TC-TR Breakeven condition: AR= AC
A B C
TR £80,000 £120,000 £150,000
TFC £100,000 £100,0000 £100,000
TVC £100,000 £120,000 £140,000
TC £200,000 £220,000 £240,000
A B C
1. Loss if shutdown: £100,000 1. Loss if shutdown: £100,000 1. Loss if shutdown: £100,000
2. Loss if continue: £120,000 2. Loss if continue: £100,000 2. Loss if continue: £90,000
3. Continue in S/R: no 3. Continue in S/R: yes or no 3. Continue in S/R: yes
Shutdown condition: AR= AVC:
doesn’t imply profit is being made
Breakeven condition tells us about
profit
C1
AR=AC: Normal profit
P1
AR> AC: Supernormal profit
AR<AC: Subnormal profit
(shutdown move FOP elsewhere)
, Price, Loss= Shutdown
cost,
revenue
C1
P1
Subnormal
profit
Arguments in favour of patent protection:
§ Encourages Research and Development
§ Encourages exploitation of external economies of scale e.g. research projects with universities
§ Innovation is encouraged e.g. gains in dynamic efficiency that then reduce costs for consumers
§ Rewards – pharmaceutical
§ Can create barriers to entry
§ Secures exclusivity and market position…
§ Macro benefits, e.g. multiplier effects, gains in export competitiveness, a source of economic growth
§ Investment in research in turn in the long run may benefit society as a whole e.g. external benefits from health
research, environmental patented technology
Arguments against use of patent protection:
§ Patents allow supernormal profits to be made – a transfer of wealth to highly profitable monopolists potentially
at the expense of consumers
§ Patents may stifle competition or innovation by others
§ Disadvantages of monopoly e.g. loss of allocative efficiency as prices charged are well above MC
§ May cause x-inefficiency due to the lack of contestability in the market
§ Costs of enforcing patents
, Monopolistic Competition Characteristics
1. There are many sellers in a monopolistically competitive market. Small firms must therefore compete with each
other in order to survive in the market place.
2. The goods and services produced are slightly differentiated- implication is that firms are price makers, with a
downward sloping demand (AR) curve but not to the same extent as monopolies are. The fact that many other
firms exist selling similar products ensures that prices cannot be increased too high otherwise firms will lose
market share as consumers switch to decent alternatives.
3. Very small market share/ power
4. There are low barriers to entry and exit for firms. If firms are attracted by supernormal profits they can enter
with ease and if firms want to leave due to losses being made, they can do so without difficulty. This implies that
short run supernormal or subnormal profit will not be sustained in the long run.
5. As goods produced are only slightly differentiated, still quite similar to products of other suppliers, firms compete
strongly on non-price factors such as branding and advertising to develop loyal customer base - inc MS
6. Some control over price
7. Firms are profit maximisers producing where marginal cost = marginal revenue at all times and consumers are
utility maximisers consuming only up until price equals their marginal utility.
Examples: EE (data sharing), Hotels, hairdressers. Product range, organically sourced, opening hours, experience,
customer service,
Monopolistic competition- not the same as Assumptions:
monopoly
§ Many small producers (low concentration ratio)
§ A form of imperfect competition and can be § Very small market share/power
found in many real world markets § Low barriers to entry and exit
§ An extension of the perfect comp § Some control over price
§ Basics are similar to perfect comp § Product differentiation
§ ‘product differentiation’ instead of § These two assumptions lead us to having a downward sloping
homogenous goods demand curve
This cannot be sustained in the l/r run however due
to supernormal profits acting as an incentive for new
firms to enter the market and low barriers to entry
allowing this to actually take place.
This shifts the demand curve for the individual firm
to the left, a process that keeps happening until AR is
tangential to AC and normal profit is being made.
Firm has now reached a long run stable equilibrium,
profit max at normal profit with price P2 and Quantity
Q2. Long run in monopolistic competition is therefore
Monopolistic competition- firm behaviour denied by normal profit
§ In the s/r a profit maximising monopolistically
competitive firm will produce where MC=MR, with output
at Q1 and price of P1. P1. At this point of production,
AR=AC with supernormal profits being made indicated by
the shaded area. The price making power of the firm, due
to slightly differentiated goods being made, allows
supernormal profits to exist in the short run.
