3.4 Market Structures (Edexcel A Level Economics A)

Firms will follow the shutdown rule. This means firms exit the industry in perfect competition when facing losses.

Normal profit is the minimum level of profit required to keep a firm operating in the long run. This is where total revenue = total cost.

The characteristics of perfect competition are:

• many buyers and sellers who are price takers

• no barriers to entry or exit

• buyers and sellers have perfect knowledge

• homogeneous products.

Perfectly competitive firms maximise profit by producing at the level of output where marginal cost equals marginal revenue (MC = MR).

In perfect competition, profits return to normal profit in the long run as firms enter or exit the industry in response to short-term profits or losses.

True.

Firms in perfect competition are price takers due to the large number of sellers with perfect information selling a homogenous product.

The supply curve of a perfectly competitive firm is its marginal cost curve (MC) above the average variable cost curve (AVC).

Firms exiting the market in perfect competition shift the industry's supply curve to the left. This lowers the market price and eliminates supernormal profits.

Firms should follow the shutdown rule. A business will exit the industry in perfect competition when facing losses.

Normal profit is the minimum level of profit required to keep a firm operating in the long run. This is where total revenue = total cost.

In perfect competition, the price (AR) equals marginal revenue (AR =P= MR). This is because firms are price takers.

A firm in perfect competition achieves allocative efficiency by operating at the output where price or average revenue equals marginal cost (AR = MC) in the long run.

The average revenue curve in perfect competition is horizontal as demand is perfectly price elastic. This is because firms are price takers.

False.

Firms in perfect competition cannot influence market price as they are price takers.

The characteristics of monopolistic competition are:

• many small firms

• low barriers to entry and exit

• slightly differentiated products

• some price-setting ability.

Firms in monopolistic competition maximise profits by producing at the level of output where marginal cost equals marginal revenue (MC = MR).

In monopolistic competition, profits return to normal in the long run as firms enter or exit the industry in response to short-term profits or losses.

False.

Firms in monopolistic competition have a small amount of market power due to some product differentiation.

The demand curve for a firm in monopolistic competition is downward sloping due to product differentiation.

Product differentiation in monopolistic competition allows firms to have some price-setting ability and customer loyalty.

In monopolistic competition, price or average revenue is above marginal cost (AR > MC) due to firms having some market power.

Excess capacity in monopolistic competition is when firms produce less than the most efficient level of output in the long run.

Monopolistic competition differs from perfect competition in that firms have differentiated products and some price-setting ability.

In monopolistic competition, the profit-maximising point is where marginal cost equals marginal revenue (MC = MR) but price or average revenue (AR) exceeds marginal cost (MC).

False.

Firms in monopolistic competition can make supernormal profits in the short run but only normal profits in the long run.

Advertising in monopolistic competition can increase product differentiation and brand loyalty, increasing a firm's market power.

The characteristics of an oligopoly market are:

• high barriers to entry and exit

• a high concentration ratio

• interdependence of firms

• product differentiation.

A concentration ratio is calculated by totalling the market shares of the largest firms in an industry. Typically this is the top 3, 4, or 5 firms. If CR2 = 70%, this means the two largest firms in the industry jointly control a 70% market share.

Collusive behaviour in oligopolies means firms cooperate either overtly or tacitly to fix prices or restrict output. This reduces competition.

Overt collusion is when firms explicitly agree to limit competition or raise prices (price fixing). This is a spoken or written agreement which illegal in most countries.

Tacit collusion is when firms do not formally agree to cooperate but closely monitor each other's behaviour. Firms might compare their prices to a competitor and price match.

Game theory in oligopoly markets is when a framework used by firms makes optimal decisions in circumstances with high levels of interdependence.

The dominant strategy in game theory is the one that yields the best outcome for a player regardless of what other players do.

A price war is when competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share.

Predatory pricing is the practice of lowering prices when a new competitor joins the industry to drive them out. This often means setting the price (AR) below the average cost of production (AC).

Limit pricing is a strategy used by businesses to prevent possible new competitors from entering the market. This is done by setting the price or average revenue (AR) at the average cost (AC) of production.

False.

Non-price competition is very important in oligopolies. Strategies such as branding and loyalty schemes help to increase product differentiation.

The prisoners' dilemma in the game theory model illustrates why two rational individuals might not cooperate even when it's in their best interests to do so.

A pure monopoly is a market structure with a single seller, no substitute products, and complete market power to set prices and control output. It's concentration ratio is CR1=100%.

A monopoly maximises profit by producing at the level of output where marginal cost equals marginal revenue (MC = MR).

The UK Competition & Markets Authority (CMA) defines a legal monopoly as any firm with a 25% or more market share.

True.

Monopolies always make supernormal profits in the long run. Very high barriers to entry prevent competition.

Price discrimination is when a firm charges different prices for the same product to different consumers for reasons not associated with costs.

Third-degree price discrimination is when a firm charges different prices to different consumers for the same product based on their willingness to pay.

The conditions necessary for third-degree price discrimination are:

• market power

• different consumer price elasticities of demand

• the ability to prevent reselling

• the costs of separating consumers do not exceed the extra revenue gained.

Third-degree price discrimination increases total profits compared to charging a single price to all customers.

A natural monopoly occurs when the optimum number of firms in the industry is one. This is due to significant high barriers to entry, such as infrastructure costs.

Natural monopolies are typically regulated by the government through measures like maximum prices or price caps to protect consumers.

False.

While monopolies often lead to productive and allocative inefficiencies, they can potentially benefit consumers through economies of scale or investment in innovation. They can be dynamically efficient.

In monopolies, cross-subsidisation is when supernormal profits from one product area are used to support another product area that may be less profitable.

A monopsony is a market structure where there is a single buyer in the market.

The main characteristics of a monopsonist are wage-setting power and being a significant purchaser of a large section of the market's supply.

False.

A pure monopsony is actually very rare. There are many cases of dominant buyers of labour or products. For example, the NHS in the UK is a dominant buyer but it is not the single buyer of labour and medical equipment.

The power of monopsonists can force suppliers to accept lower prices. This can drive some suppliers out of business or cause them to switch resources to more profitable industries.

An example of a monopsony in the UK labour market is the National Health Service (NHS) as the dominant purchaser of nursing labour.

Monopsony power can lead to decreased product quality. Suppliers may attempt to cut their own costs in response to price pressure from the monopsonist.

Suppliers may benefit from a monopsony through an enhanced reputation. An association with a large, well-known buyer can potentially increase sales volume.

The monopsony power of supermarkets has forced many dairy farmers to accept prices below the average costs of milk production. This has led to the closure of many dairy farms in the UK.

False.

While monopsony power can lead to lower consumer prices, it may also result in decreased product quality or reduced supply in the long run. The monopsonist may not pass on lower prices to the consumer.

Monopsony power can suppress wages in some industries, particularly where the government is the majority purchaser of labour. For example, teachers or nurses.

The long-term impact of monopsony power on an industry can reduce supplier numbers, decrease innovation and cause potential supply chain issues.

The employees of a monopsonist might benefit from higher wages due to increased profits. They may, however, face ethical dilemmas regarding the treatment of suppliers.

A perfectly contestable market is when there is costless entry into a market and no exit costs.

Hit and run competition is when short-run supernormal profits act as a signalling mechanism for new firms to enter the market, extract profit and then leave.

False.

Contestable markets have low or no barriers to entry.

Contestable markets affect the prices that businesses charge by altering their strategy from profit maximisation to limit pricing. This involves setting a lower price (AR) equal to the average cost (AC).

Sunk costs are expenses that have already been incurred and cannot be recovered when the firm leaves the industry. For example, spending on advertising.

Sunk costs affect market contestability by decreasing contestability. Firms will be more hesitant to enter or leave markets with high sunk costs.

A barrier to entry is a condition that makes it difficult or expensive for a firm to enter a market in order to compete with existing suppliers.

True.

Patents are an example of a legal barrier to entry.

A barrier to exit is a factor such as sunk costs that deters a firm from leaving a market. It makes it difficult to leave even if the firm is making a loss.

A barrier to entry that entails possessing resources that are necessary for production is the ownership of essential factors of production such as land. This is an innocent barrier to entry.

Economies of scale act as a barrier to entry because an increase in the level of output results in a lower average cost. This makes it difficult for new firms to enter and compete. This is a strategic barrier to entry.

Anti-competitive practices are actions by competitors that aim to restrict competition. Examples are cartel agreements, predatory pricing, limit pricing and aggressive takeover activity.