4.1.5 – Perfect Competition, Imperfectly Competitive Markets & Monopoly

    79 – Market Structures

    In Real Life theres a Spectrum of Different Market Structures
    • in a perfect market all products are homogenous so firms
    compete using price, but in practice firms compete in

    other ways than on price e.g.
    • In real life, markets fall in-between these extremes
    o Perfect competition pure monopoly
    • Factors that distinguish between different markets are:
    1. Number of firms
    2. Barriers to entry and exit
    3. Degree of product differentiation and price strategies

    Number of Firms in a Market – this varies in all 4 markets studied
    Degree of Product Differentiation – with larger amounts of firms in the market there more differentiation
    Barriers to Entry
    • Barrier to entry is any potential difficulty or expense a firm might face through entering a market
    • The extent of the barriers determines:
    o How long it will take or how expensive it will be
    o If new entrants will be successful
    • Barriers to entry allow firms already in the market (incumbent firms) to make supernormal profit, before new
    entrants enter the market and compete these away. How long this profit is made for depends upon:
    o The height of barriers to entry
    o The level of supernormal profit being earned – larger profits mean new entrants arrive quickly
    • In a pure monopoly market, no new firms can enter the market so theres only one seller
    Barriers to Entry can be Created in Various Ways
    • They are created for various reasons for e.g.
    1. Tendency of incumbent firms to create or build barriers
    2. Nature of industry leading to uncontrollable barriers
    3. Extent of government regulation and licensing
    1. Barriers to entry due to incumbent firms’ actions
    o Innovative new product (product differentiation)
    o Patented
    o Strong branding and advertising
    o Predatory pricing
    o First Mover Advantage
    2. Barriers to entry due to the nature of an industry
    o Sunk costs (barriers to exit are high so acts as a barrier to entry making entry to market risky )
    o Economies of scale that a new firm can’t reach straight away
    o High fixed costs
    3. Barriers to entry can be due to government regulations
    o If an activity requires a license it restricts speed and number of new entrants
    o New factories may need planning permission before building
    o Theres also regulations with health and safety fir employees of firms

    New entrants May have their own Advantages
    • not all new entrants are small firms competing against giant firms
    • sometimes new entrants are large companies wanting to diversify into new markets
    o due to their large financial resources so may be more successful when entering markets – The objectives of firms
    • The models we use have the assumption that firms aim to profit maximise (MC=MR)
    • But they could have other aims like
    o Survival
    o Growth
    o Quality
    o Maximising sales revenue
    o Increasing market share
    • Some firms may have Satisficing behaviour where
    businesses aim for minimum acceptable levels of
    achievement in terms of revenue and profit, to keep
    shareholders happy.

    • Divorce of ownership
    o The separation of ownership and control is
    associsated with publicly held business
    corporations in which the shareholders possess
    little or no control over management decisions. – Perfect Competition

    Characteristics of Perfectly Competitive Markets (Don’t Exist
    in Real World)
    • Infinite number of suppliers and consumers – no market
    power (0% conc) firms are price takers
    • Consumers have perfect information – well informed
    • Producers have perfect information – all production methods the same (no low-cost way)
    • Products are homogenous – products perfect substitutes for each other
    • No barriers to entry –firm can join and leave industries easily
    • Firms are profit maximisers – firms are all trying to maximise profits so produce where MC=MR
    Perfect Competition can cause Allocative Efficiency
    1. The Rationing, Signalling and Incentive functions work perfectly in perfect markets. In particular:
    a. All firms are price takers (market sets price)
    b. Consumers and producers have perfect knowledge and theres no barriers to entry
    (firms can recognise and act on incentives changing output level or entering/ leaving markets)

    2. Allocative efficiency occurs when P=MC or P=MU
    a. Allocative efficiency and externalities
    i. If there’s externalities allocative efficiency can’t be
    ii. Allocative efficiency occurs when P= MSC (including
    iii. With negative externalities then
    MPC< MSC meaning P< MSC so theres allocative
    inefficiency as theres overproduction &

    Perfect competition Profits
    • No firm makes supernormal profit in the long run this is because
    o Short term profits attract new firms (no barriers to entry) so more supply causes shift till excess profits
    are competed away and a new equilibrium is reached at P1
    Firms leave Markets that Isn’t Profitable in the Long Run
    • if the market price (AR) falls below a firm’s AC, the is making less than normal profit
    • the firm then leaves the market but in the short run theres two possibilities:
    o if the market price (AR) is above the firms AVC then they may continue trading temporarily
    o if the market price (AR) is below the firms AVC then they leave the market immediately

    Perfect Competition leads to Productive Efficiency
    • productive efficiency – making sure production costs are as low as possible so prices are low for consumers too
    • in perfect competition this occurs when all firms try maximising profits
    • in the long run equilibrium of perfect competetion firms produce a quantity of goods so MR=MC
    o output above this (MC>MR) reduces profit, so firms won’t produce
    o output below this (MR>MC) increases profits, so firms expand output


    X- efficiency

    • having to compete gives firms incentives to reduce waste and inefficiency
    • x- efficiency measures how successfully a firm keeps its costs down
    • x- inefficiency can be caused by:
    o using factors of production wastefully
    o paying too much for factors of production
    • productive efficiency is only achieved if we assume theres no economies of scale
    Perfect Competition Doesn’t Lead to Dynamic Efficiency
    • Firms don’t want to take risks in research & development or invest in new
    technology as they earn only normal profit, and only do it for an adequate reward.
    Perfect Competition Leads to Static Efficiency
    • If allocative and productive efficiency are achieved it is called static efficiency.
    o This doesn’t last forever as consumer taste and technology changes
    Governments try Encourage Competition in Markets
    • Perfect markets lead to efficient long run outcomes in theory as firms are productive and allocatively efficient
    (so are forced to be x-efficient)
    • Governments want to ensure firms:
    o Are forced to produce efficiently, reducing costs
    o Set fair prices to consumers
    o Innovate to create new products and new production processes
    • Theres policies governments implement to increase competition in the economy:
    ▪ Subsidies
    ▪ Comparison information to increase consumer knowledge
    ▪ Bring more consumer choice and competition in the public sector
    ▪ Privatise and deregulate large monopolistic nationalised industries
    ▪ Discourage mergers and take overs which reduces competition
    ▪ Encourage more international competition – Monopolistic Competition

    Monopolistic Competition Resembles Lots of Real-Life Industries
    • It’s between Perfect and Monopoly Markets
    • Conditions in Monopolistic Competition

    o Some product differentiation – either due to advertising or real differences in products
    ▪ So, the seller has some form of price-making power
    ▪ Each sellers demand curve slopes down
    ▪ Smaller product differences cause a more price elastic
    demand for product
    o Either no or very few barriers to entry
    ▪ High supernormal profits cause new entrants to join industry


    Short Run Position

    • Supernormal profits are made only in the short run due to few barriers
    to entry
    o Profit maximised where MC=MR
    o The supernormal profits being Ps to ACs
    o this is the same diagram as for monopolies just more elastic due
    to substitutes available

    Long Run Position

    • In the long run normal profit are made
    1. As barriers to entry are low, new entrants join the industry
    causing demand to shift to the left
    2. New entrants continue to join until:
    o Only normal profits can be earned which is where
    P=AR=AC so where AR and AC touch tangentially
    o At this quantity MC=MR (bottom dot)
    3. This isn’t productive or allocatively efficient as:
    o Not producing on lowest point of AC
    o Equilibrium Price is greater than MC
    4. However, they are still more efficient that a monopoly

    Prices in Monopolistic Competition are Higher than Perfect Markets
    The length of time taken for new entrants to reduce prices to normal profit levels varies:
    • If it takes a long time, market will resemble a monopoly
    • If it takes a short time, market will resemble a perfect competition
    • This is why firms invest to differentiate products to retain their price making power = more abnormal profit
    • In Monopolistic competition the firm doesn’t produce at the lowest point on the AC curve, so prices are higher
    than in perfect competition
    o This is because they spend money on differentiating products and brands
    o They also restrict output so don’t benefit from econs of scale
    o They have lower prices than monopolies
    Monopolistic Competition Doesn’t cause Dynamic Efficiency
    • Lack of barriers to entry mean firms are unlikely to invest excessively on innovation, so theres less dynamic
    • In the long run the absence of supernormal profit means not much money for investment – Oligopolies

    Concentration Ratios show How Dominant Firms in a Market Are
    • Some industries are dominated by a few companies
    • The level of domination is measured by a concentration ratio
    Oligopolies is a Market:
    1. Dominated by a few firms
    2. High barriers to entry
    3. Firms offer differentiated products
    4. Firms are interdependent – the actions of each firms will affect
    the others
    5. Firms use competitive or collusive strategies to make interdependence work to their favour
    Firms in an Oligopoly can Compete or Collude
    • Firms in oligopolies face a choice of the long-term strategy they adopt;
    o this decision will be affected by how other interdependent firms in the market act
    • This means theres different possible scenarios in an oligopolistic market:

    Collusion can Bring Similar Results to a Monopoly
    • Collusive Monopolies lead to higher prices and restricted output
    o Hence, leading to allocative and productive inefficiency
    o Firms in collusive oligopolies often have the resources to invest in more
    efficient production methods and achieve dynamic efficiency (theres
    not always an incentive to innovate)
    • They make supernormal profits as they don’t lower price even when they could
    • Firms colluding on price may compete in other ways for example:
    o Differentiation of products from their competitors by improving products or branding
    o Sales promotions
    o New export markets
    • New entrants may also face predatory pricing

    Oligopolies Can be Good
    • Collusive oligopolies are argued to be:
    1. Not as bad
    2. Unstable
    3. Both
    • It’s argued formal collusion is unlikely to occur as its illegal, and informal collusion is likely to be temporary as:
    one firm will “cheat” lowering its price to gain an advantage creating a price war.
    • Even in a collusive oligopoly:
    o If firms aren’t competing on price, then non-price competition might even be stronger leading to
    dynamic efficiency (good for consumers as lead to innovation and improvements)
    o Firms are unlikely to raise prices to high levels, as this would entice new entrants to join the market
    • Competitive oligopolies can achieve high levels of efficiency
    Interdependence in Oligopolies
    Game Theory can Help Understand the Results of Interdependence
    • In oligopolies, each firm is affected by the behaviour of the others
    • The game theory –
    o Where two or more players are trying to work out what to do to further their own interests
    o The fate of each player depends of their own decisions, and the decisions of everyone else
    The Kinked Demand Curve Model is used to Explain Price Stability
    • The kinked demand curve shows why prices are quite stable, even in competitive oligopolies
    • Theres two assumptions in the model
    o If one firm raises its prices, the other firms won’t (due to substitutes being cheaper)
    o If one firm lowers its prices, the other firms will aswell (but lowering price lowers firms market share)
    • The outcome is that firms have no incentive to change prices and if they raise or lower prices, they lose out.
    • This results in price stability for prolonged periods of time

    However, the kinked demand curve has limitations
    • It doesn’t explain how the price was arrived at in the first place.
    • Firms may engage in price competition.

    Kinked Demand Curve Model Describes Just One Possible Outcome
    • This means it doesn’t explain the behaviour of firms in every oligopoly
    • The assumptions in the kinked demand curve model may not be
    appropriate for every oligopoly. Therefore, other models may
    describe oligopoly markets better. – Monopoly and Monopoly Power

    A Monopoly is a Market with a Single Seller
    • A monopoly is a market with only one firm in it so it has
    100% market share
    • Even markets with more than one seller, firms have monopoly power if they can influence price (price makers)
    • Monopoly power may occur because of:
    o Barriers to entry – preventing new firms entering due to compete away profits
    o Advertising and product differentiation – if consumers think products are more desirable than those
    produced by other firms
    o Few competitors in market – if the markets dominated by a small number of firms

    A Monopolist makes Supernormal Profit in the Short and Long Run
    1. The diagram shows how a firm behaves in a monopoly market
    a. If firms want to maximise profits they will do it where MC=MR
    b. If a firm produces a quantity Qm they could set a price of Pm on the
    demand (AR) curve
    c. The AC of each unit is ACm
    d. Difference between ACm and Pm is the supernormal profit per unit
    2. Due to the barriers to entry these aren’t competed away so this profit is
    sustained in the long run
    3. So, the long run equilibrium position for a monopolist remains the same
    Monopolies are Productively and Allocatively Inefficient

    The above diagram shows
    o MC isn’t equal to AC at the long run equilibrium position for a monopoly so it isn’t productively efficient
    o The price charged is also greater than MC so it isn’t allocatively efficient
    • In the diagram on the right the red area shows some of the consumer surplus that would’ve existed at market
    equilibrium price Pc is given to producers

    Monopolies have Drawbacks
    • Monopolies aren’t needed to innovate or respond to changes in consumer
    preferences to make profit
    • They don’t increase efficiency, so x-efficiency is high
    • Consumer choice is restricted as no alternative products
    • Monopsonist power may exploit suppliers
    Natural Monopolies Have a Lot of Monopoly Power
    • some industries lead to a natural monopoly
    o industries with high fixed costs or have large economies
    of scale lead to natural monopolies
    o a monopoly might be more efficient than having lots of
    firms competing, for e.g. water supply

    natural monopolies have continuous economies of scale LRAC will
    fall as output increases so MC is lower than AC
    o a profit maximising natural monopoly will restrict output to where MC=MR
    • governments may not break natural monopolies as it could reduce efficiency
    o but it may provide subsidies to the natural monopoly to increase output to where Demand = Supply (Qs)
    reducing price as shown.

    Monopolies have some Potential Benefits
    1. A monopolist’s large size allows it to gain an advantage from economies of scale. If diseconomies of scale are
    avoided, this means it can keep AC low.
    2. The security a monopolist has in the market means it can take a long-term view and invest in developing and
    improving products for the future (leading to dynamic efficiency)
    3. Increased financial security means a monopolist can provide stable employment for its workers
    4. Intellectual property rights (IPR’s) gives firms protection (patents copyright) so its less risk when innovating
    Monopsony Is a Single Buyer in A Market
    • So, they dominate the market and are price makers. For e.g. supermarkets
    • If a firm is a single buyer of labour in a market, it can exploit its power and lower the wages of its employees
    Difference between Monopolies and Monopoly Power
    • Pure monopoly is a market with one seller
    • Monopoly power is the ability to influence price of a good in a market, by controlling supply so it’s a price maker
    • Firms producing essential goods & services with no substitutes have monopoly power (> Inelastic > price power)
    Monopolies can Bring Benefits to an Economy
    • Some markets are more efficient at allocating resources with one producer who can
    exploit economies of scale reaching MES
    o These cost savings can go to consumers and help international competitiveness
    o They can use profits for research into new production methods and innovation – Price Discrimination

    Price Discrimination means charging Different Prices for the
    Same Product
    1. Price discrimination occurs when a seller charges different
    prices for the exact same product
    2. Conditions that need to be satisfied for a firm to use price discrimination is:
    a. Seller must have some price making power. So, monopolies and oligopolies can price discriminate
    b. Firms can distinguish separate groups of customers with different PED. So, more group division is better
    for a seller
    c. The firm must prevent customers who bought a product at a low-price reselling it for a higher price
    • Theatres and cinemas offer cheaper prices for certain groups (students)
    • Window cleaners
    • Train tickets at rush hour
    • Pharmaceutical drug prices in different countries
    Price Discrimination transfers Consumer Surplus from Consumer to Producer
    1. Price discrimination turns consumer surplus into additional revenue for the seller
    2. There are different degrees of discrimination:

    Price discrimination is Good for Sellers and Possibly Bad for Others
    • Firms receive increased revenue and whether it’s fair or unfair depends on what happens to the extra revenue
    1. The extra revenue could improve products, or invest in more efficient methods leading to lower prices
    2. The AR is greater than MC so does not lead to allocative efficiency as P doesn’t =MC
    3. Consumers aren’t treated equally but often the people who earn higher incomes pay more – so redistributes
    income – Dynamics of Competition and Competitive Markets
    Short term
    o Firms are encouraged to make cost savings by: Increasing productivity and Innovating
    o This allows firms to cut the price of products
    o Consumers benefit from lower prices, more choice and higher quality products
    o Firms also compete on non-price factors like quality of service
    Long term
    o Benefits relate to the efficient allocation of resources
    • Creative destruction is a process through
    which something new brings about the
    demise of whatever existed before it – Contestability

    A Contestable Market is Open to New Competitors
    • Contestability is how open a market is to new competitors
    • In a contestable market
    o The barriers to entry are low so if abnormal profits are made new firms enter
    o Supernormal profits can be made by new firms (in short run)
    • So increased competition occurs when incumbent firms are making large supernormal profits
    o So incumbent firms keep the price level where large supernormal profits aren’t made
    High Barriers to Entry mean Low Contestability – so less entrants
    1. Barriers to entry are high if
    o There are patents on products or production methods – stopping other firms copying
    2. Advertising by firms creates brand loyalty
    3. Threat of predatory pricing
    4. Trade Restrictions – tariffs or quotas
    5. Sunk Costs are High – i.e. investment in specialised equipment and advertising
    Hit and Run Tactics can be Used in Contestable Markets
    • The low barriers to entry and exit in a contestable market can cause new entrants to hit and run
    • Hit and run tactics
    o Entering a market with supernormal profits then leaving the market once normal profit is earnt
    o Sunk costs can be reduced in this by leasing equipment
    Contestability of a Market Affects Behaviour of Incumbent Firms
    • In a contestable market, it’s the threat of competition from new firms that affect incumbent firms’ behaviour
    o For e.g. high profits mean new entrants
    o So, lowering price to earn lower profits may maximise profits in the long run
    o Incumbent firms want to create high barriers to entry if possible via advertising etc
    o In the long run, firms in a contestable market go towards allocative and productive efficiency as
    supernormal profits are eroded
    Technological Change Has Big Impact on Market Structure
    4. Technological change through innovation and invention can raise or lower barriers to entry
    5. Technological has an impact on:
    o Structure of market
    o Production methods
    o Consumption of goods and services
    6. Invention and innovation can lead to:
    o Improvements in capital equipment – leading to better quality products
    o Barriers to entry reduced or increased
    o Monopoly power to firm who invented innovation
    o Larger economies of scale
    New Technology Can Lead to Creative Destruction
    • Creative destruction is the idea markets are constantly changing due to innovation and invention of products
    and production methods
    o This causes job loses but new jobs will be made in new markets
    • Technological changes lead to creative destructive
    o As firms (even big ones) are put out of business due to innovation by new entrants seeking the profit
    o This also means large incumbent firms have incentive to invest so they can innovate keeping barriers to
    entry high – Market Structure, Static Efficiency, Dynamic
    Efficiency and Resource Allocation

    Dynamic efficiency – when firms lower their average cost
    o R&D
    o Investment in human and non-human capital
    o Technological Change
    • Static efficiency – when firms are allocative and productively efficient
    o Productive efficiency – minimising AC (MC=AC)
    o Allocative efficiency – price = MC – Consumer and Producer Surplus




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