What determines the behaviour of firms?
Market Structures
Most competitive
Monopolistic
Competition
Perfect
Competition
•
•
•
•
Least competitive
Oligopoly
Monopoly
Supply and demand determine market structure.
In turn these will determine conduct (such as pricing) and performance (such as profitability).
This means that markets which are highly concentrated are able to set high prices or engage in
anti-competitive practices.
These result in abnormal profits and inefficiencies.
Summary of characteristics of different market structures:
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Number of firms
Many small firms
Many small firms
A few large firms
(maybe with other
small ones as well)
One
Type of product
Homogenous
Similar
Similar
Unique
Knowledge of
other firms’ profits
and technology
Perfect
Imperfect (debatable
– a hairdresser may
know a competitors
prices, by looking at
their window, and
might be able to
guess costs and
revenue)
Imperfect
(Imperfect)
Entry/exit barriers
None
Low
High
High
Price-setting
powers
Price taker
Limited
Limited (depends on
degree of
dominance)
Price setter (can set
price and quantity)
Allocatively
efficient?
Yes (long-run)
No
No
No (but there are
economies of scale)
Productively
efficient?
Yes (long-run)
No
No
No (yes if state
owned)
Real?
No
Yes
Yes
Yes
1 Perfect Competition
Market characteristics:
1. Many buyers and many small sellers
2. All firms and consumers enjoy perfect knowledge of market conditions
3. Homogenous products
4. Complete freedom of entry to and exit from the market in the long run – i.e. the market is perfectly
contestable
5. Price taker
Because of the first three conditions the firms are price takers – they have to accept the market price as
raising prices will lead to complete substitution away from the firm’s product, i.e. the firm’s demand curve
is perfectly elastic and there is a constant AR and MR curve.
This also means that there is no incentive for technological change, however, as any idea would
immediately be available to all other firms. There would therefore be no way for the firm to recover
research costs.
Short run equilibrium:
• The graph shows the situation for each individual firm.
• Firms have to accept the price determined at industry level and then supply the quantity of output
that will maximise the firm’s profits.
price output •
•
In the short run it is possible to make supernormal profits.
However the output produced is not at minimum possible average cost in the short run, i.e. it is not
productively efficient.
Long run equilibrium:
• Freedom of entry means that only normal profits will be made in the long run.
• This is because short term supernormal profits will attract new firms into the market and erode
profits.
• As new firms enter, the supply curve for the industry shifts rightward, meaning that the price level
drops and similarly the AR=MR=D curve for individual firms falls to accommodate for the change in
price.
• If in the short run losses were experienced, firms would leave the industry and long run equilibrium
would be restored by a subsequent rise in prices.
2 •
In the short run, firms continue to enter or leave the industry until normal profits are made, at
price price output output which point there is no further incentive to enter or leave the industry.
Shut-down point:
• This occurs when a perfectly competitive firm is not covering average variable costs in the short
run.
• I.e. it may be feasible for a firm to make a loss in the short run, as long as it covers the cost of
making the good and therefore makes a contribution to the fixed costs.
• For example, if the fixed costs for producing a good are £100,000, then closing the firm will induce
costs of £100,000 whereas keeping the firm open will only make a loss of £70,000, therefore the
firm will not shut down.
Supply Curve:
• In the short run the supply curve is therefore the marginal cost curve above the average variable
cost.
• At this level of output, when the marginal revenue crosses the marginal cost, the firm will remain
open, as it makes a contribution toward fixed costs.
Monopoly
Market characteristics:
1. One firm
2. High barriers to entry and exit
3. Unique product
4. Imperfect knowledge
5. Price setter
Equilibrium:
• The monopolist has the power to be a price maker.
• It will therefore sell whatever quantity consumers will buy at that price (Demand = AR).
• If the monopolist is a profit maximiser, then they will choose the quantity where MC=MR as shown
in the graph below.
3 •
Any supernormal profits can persist in the long run because of high barriers to entry – the
monopolist can set high prices without the fear that another firm could enter the industry and shift
demand.
Comparison to perfect competition:
Perfect Competition
(Long-Run)
Monopoly
Profix maximisers
Yes
Yes
Allocatively Efficiency
Allocatively efficient – price is equal
to marginal cost.
Allocatively inefficient – price is set at
a higher level than marginal cost.
Productively Efficiency
Productively efficient – output is at
the lowest point of the AC curve
(where MC = AC).
Productively inefficient – the output is
set at a level before the lowest point
on the AC curve.
X-inefficiency
None.
X-inefficiency (a type of internal
efficiency) may arise in monopolies.
This is because as entry barriers
protect a monopolist it is under little
pressure to behave efficiently and
minimise costs (price can be raised to
maintain profits and there is little
pressure to behave efficiently and
minimise costs.
Price
Prices are lower compared to
monopoly.
Prices are higher compared to perfect
competition.
Quantity
Quantity is higher compared to
monopoly.
Quantity is lower compared to perfect
competition.
4 Price discrimination:
A monopolist might choose to price discriminate. If firms price discriminate, the monopolist can appropriate
some of the consumer surplus in the form of extra monopoly profits.
There are three necessary conditions for price discrimination:
1. The firm must be a price maker, there must be high barriers to entry and a degree of monopoly
power.
2. Different PEDs in different markets:
- Raising price to consumers with inelastic demand, lowering it for elastic demand to increase
revenue.
3. Resale preventable:
- Once the market has been divided, the sub markets need to be kept separate.
- Price discrimination will not be completely effective if people can buy the product in a low price
sub-market and then re-sell it in a higher priced sub-market.
How price
-
discrimination can be achieved:
Time barriers – e.g. peak and off peak travel
Geographical barriers – e.g. goods being sold at different prices in different counties
Income barriers
Age barriers – e.g. differently priced tickets for children, students, adults and pensioners
Types of price discrimination:
1. First degree:
- The producer charges each individual consumer the highest price they are prepared to pay.
- This way they capture the entire consumer surplus.
- Difficult to find examples of this type of price discrimination – it is primarily theoretical as it
requires the seller to know the maximum price that every consumer is willing to pay.
- Online auctioner e-Bay has some similarities – the seller will capture the entire consumer
surplus if the auction is hotly contested (e.g. if there are two identical games on sale and ten
bidders then the two highest bidders will pay the maximum price they are prepared to pay for
the games).
- The demand curve is actually the marginal revenue curve with this type of discrimination – the
price does not have to be lowered to sell additional units of the product.
Advantages: the market is still entirely efficient and there is no deadweight loss to society.
Disadvantages: it is the opposite of a perfectly competitive market – the consumer receives the bulk of the
surplus in perfect competition – in first degree price discrimination the seller captures the entire consumer
surplus.
2. Second degree:
- When a firm has surplus capacity.
- Possible for potential consumers to be targeted by a lower price.
- These consumers would not normally buy the product.
- E.g. football clubs in the lower divisions – often not filled to capacity so sometimes introduce
special offers for adults to bring children who only pay £1 to gain admission (‘kid a quid’).
5 -
This type of pricing adds to revenue but adds little to costs.
As long as the special price is above marginal costs it results in increased profits.
E.g. bulk buying – it is often seen in industrial processes, where a firm can be rewarded for the
quantity of a product it buys.
3. Third degree:
- Distinguishing between two sub-markets.
- It can be based on regional, age or time differences.
- E.g. sale of child and adult railway tickets and the sale of peak and off peak telephone,
electricity and gas services.
- Most common type of price discrimination.
-
As shown on the graphs, the firm splits the market into inelastic demand (DA) and elastic
demand (DB).
The output is sold at different prices to the two markets which are kept separate.
Total cost remains unchanged (the cost of production for both sub-markets is the same) and
profits are increased.
This can only be effective if the sub-markets have different demand curves.
Is it worthwhile for a monopolist to advertise?
• Advertising does help maintain barriers to entry.
• It can be used to show that a monopolist is capable of being nice to consumers.
• In theory it will bring the monopolist higher abnormal profits, as more people might start to buy the
product (assuming the cost structure remains the same).
6 Advantages and disadvantages of monopoly:
Advantages
Supernormal profit means:
•
•
•
Disadvantages
Supernormal profit means:
Finance for investment to maintain competitive
edge.
Firms can also create reserves to overcome shortterm difficulties, giving stability to employment.
Funds for research and development.
•
•
Less incentive to be efficient and to develop
new products.
Existence of resources to protect market
dominance by raising barriers to entry.
These are important advantages in global markets.
Monopoly power means:
Monopoly power means:
Firms will have the financial power to match large
overseas competitors.
• Monopolies may also be a powerful counterbalance
to a monopsony.
Cross subsidisation (using profits from one sector to
Higher prices and lower output for domestic
consumers.
• Reduced consumer surplus compared to a
competitive market.
Cross subsidisation:
•
finance losses in another):
•
•
May lead to an increased range of goods or
services.
• These goods or services might not have been
provided otherwise.
• E.g. the provision of services that are loss-making
but provide an external benefit, such as rural bus
services.
Price discrimination:
•
This may raise the firm’s total revenue to a point
where it allows the survival of a product or service.
• It can benefit some consumers who pay a lower
price.
Efficiency:
Producers can take advantage of economies of
scale, which lowers cost per unit – if this lowers
prices then consumer surplus is higher than
competition.
• Marginal cost pricing (as practiced in perfect
competition) can actually lead to huge losses, as it
does not cover fixed costs in declining cost
industries.
• There are few permanent monopolies and the
supernormal profit opportunities act as an incentive
for rival firms to break down the monopoly through
a process of creative destruction, i.e. breaking the
monopoly by product development and innovation,
and therefore bypassing barriers to entry.
Duplication:
•
Monopolies avoid the problems of duplication and
wasteful advertising, and some industries are
natural monopolies.
•
This may raise producer surplus while reducing
consumer surplus.
Efficiency:
•
•
•
Monopolists do not produce at the most
productively efficient point of output.
Monopolies are not allocatively efficient.
Monopolists can become complacent and
develop X-inefficiencies.
Duplication:
•
7 Resources might be wasted.
Cross subsidisation might occur when a
monopolist is predatory pricing or limit pricing.
Price discrimination:
•
•
•
Monopolies deny consumers the variety and
choice which is available in competitive
markets.
Natural monopolies:
• Exist where an industry can only support one firm – typical where there are high sunk costs and
large levels of output are needed to exploit economies of scale.
• Introduction of competition by some government agency will not be possible in the long run –
neither of the competing firms would be able to obtain sufficient market share to ensure that it is
best able to exploit economies of scale.
• Exist in the supply of water, gas and electricity:
- High start up costs.
- High infrastructure costs.
- Costs of establishing a competing firm will outweigh any economic/social benefit that may
materialise.
Monopsony
Market characteristics:
• Monopsony occurs when there is only one buyer.
• e.g. If an individual wishes to work in emergency medicine in the UK, then the sole buyer of such
employees is the NHS.
• A number of firms could act together to form one single buyer.
• e.g. In the supermarket industry, where the major retailers (Tesco, Asda and Sainsbury’s) have
joined together recently to exploit the sellers and ensure that the supermarkets are able to get the
best possible price for their goods.
• Monopsony occurs usually occurs when the supply is of labour.
Advantages and disadvantages:
This sort of power may allow a firm to exploit its suppliers in the knowledge that the supplier has few
options beyond selling to the sole buyer – this can mean that cheaper prices are passed on to the
consumer, but this may be at the expense of the supplier of the goods.
Advantages
Disadvantages
• This sort of power may allow a firm to exploit its • This may be at the expense of the supplier of the
suppliers in the knowledge that the supplier has few
goods.
options beyond selling to the sole buyer – this can • E.g. supermarkets may force suppliers to pay for
mean that cheaper prices are passed on to the
better product placement in their shops.
consumer.
• The firm may not pass on the lower wholesale price
to the consumer, e.g. in the supermarket sector.
Oligopoly
Market characteristics:
1. A few large firms (possibly with many small firms)
2. Similar goods but branded
3. Imperfect knowledge about rival firms’ price and output decisions
4. High barriers to entry/exit
5. Oligopolies can set price but may decide to agree price-fixing deals with rivals to avoid price
competition
8 In oligopolies the firms are interdependent – this is due to the fact that a few firms dominate the market
selling similar goods – this means that the actions of one firm will affect the other firms directly. This type
of market typically leads to collusive behaviour among the main firms.
Competition i.e. non-collusion:
There are only a few firms – i.e. there is a high concentration ratio – firms will tend to avoid price
competition. This is because as one firm were to lower prices, others would follow and revenue may be lost
from the price war that would ensue. This means that oligopolies are characterised by non-price
competition.
Methods of non-price competition:
• Advertising
• Branding
• Product quality/innovation
• Packaging
• Free gifts
• Store loyalty cards e.g. Sainsbury’s Nectar or Tesco’s Clubcard.
Price Wars:
• When price stability breaks down.
• E.g. intense competition with petrol retailing, newspapers and air travel.
• Some firms are tempted by the hope of winning such a price war.
Collusion:
• This is where oligopolists agree formally or informally to limit competition between themselves.
• They may set output quotas, fix prices, limit production promotion or development or agree not to
poach each other’s markets.
• Attractive idea – desire to remove the uncomfortable uncertainty that interdependence brings to the
market.
• Reduces the fear of competitive price-cutting or retaliatory advertising which could reduce industry
profits.
• Collusion is most possible when:
- There are similar costs – allow for similar pricing.
- There are few firms – easier to share information between one another.
- High barriers to entry – allow firms to make supernormal profits in the long run.
- Low levels of regulation – collusion is illegal, so it is more attractive where fines are low or
regulators can be outwitted.
- Homogeneity of products – product differentiation is not a feature of the market.
9 Types of collusion:
1. Tacit Collusion:
- When firms act as if they have common pricing and output policies in place without actually
having communicated with each other.
- This is therefore difficult to control.
- E.g. where a dominant firm leads price, and other firms set the same price as the established
price leader, such as in Law Firms in the City.
- Price leadership may also occur when the conditions of a market change (e.g. during recession),
leading to the dominant firm changing price. This may lead to other firms changing their prices
by the same amount, e.g. in the UK energy sector in 2007/8.
2. Covert Collusion:
- Where firms meet secretly and make decisions about prices or output.
3. Overt Collusion:
- Where collusive agreements are made publicly and are usually global in nature, applying to
particular commodities.
- E.g. OPEC (Organisation of Petroleum Exporting Countries) sets production quotas for member
countries to regulate the world price of oil.
Kinked Demand:
• Shows the interdependence of firms and explains price rigidity.
•
•
•
Lack of incentive to change price:
- At the current price, if a firm cuts its price it is unlikely to enjoy much of a boost in demand as
other firms will soon follow suit (demand is inelastic below P).
- If a firm raises price it will lose a lot of business as competitors are unlikely to follow.
The vertical discontinuity created in the MR curve in the model means that even if the firm changed
its cost structure largely (e.g. a shift from MC1 to MC2), there would be no change in price – this
also explains price stability.
Criticisms of the model:
- No explanation as to how the price reached this level initially.
- Short run profit maximising assumption employed in the model is also questioned.
Can collusion ever be in the public interest?
• In some circumstances cartels can bring benefits e.g. the FA Premier League selling collective rights
for the coverage of sport.
10 Problems with collusion/detecting collusion:
1. Firms all have an incentive to cheat whilst in collusive agreements by producing more than agreed –
this will suppress price slightly, but the firm can still take advantage of artificially high prices as long
as the other firms don’t cheat as well (game theory).
Game theory:
- Aka the ‘prisoner’s dilemma’
- Examines the possible strategies of firms when they assume their rivals’ behaviour.
- Firms can choose between high and low risk strategies.
-
E.g. in the table, there are two firms (A and B).
They will be able to make profits of £100m if they set prices at a high level.
They each know that they can increase their individual profits by lowering prices and breaking
any collusive agreements, so obtaining £120m.
As a result of neither firm trusting the other, they both adopt the low price strategy and end up
with £80m, which is worse than if they had colluded and set a high price.
This suggests that a lack of trust between firms may lead to any collusive agreement being
broken.
Game theory shows the interdependence of firms in oligopolistic markets (the individual firm’s
revenue depends on the price of other firms).
2. In complex monopolies (firms with >25% market share in unrelated industries whose price
increases appear to be the same) it can seem as though collusion has occurred, although this is
unlikely, for example in the supermarkets and commercial banks industries in the UK.
Monopolistic Competition
Market characteristics:
1. Many small firms
2. Similar goods but some product differentiation
3. Imperfect knowledge about rivals’ firms although they may know price and be able to detect where
supernormal profits are being made
4. Low barriers to entry and exit
5. Firms can set prices to an extent because of product differentiation
Examples: hairdressers.
11 Equilibrium:
Short Run:
• There is the possibility of short run supernormal profits or losses.
• This is shown on the graph, where the shaded area represents supernormal profits.
Long
•
•
•
Run:
Lack of significant barriers to entry and exit → only normal profits being made in the long run.
Short-run supernormal profit will induce new entry.
This means that the demand curve will shift to the left until it is tangential to the average cost
curve (AR = AC).
•
Similarly, if losses are being made in the short run, some firms will leave the market, restoring
long run equilibrium.
Efficiency:
• Productively inefficient in the short and long run, as output is lower than the minimum point of
the average cost curve (MC≠AC at Q).
• Allocatively inefficient in the short and long run, as P does not equal MC (P≠MC).
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