3.4 Market Structures

• Allocative efficiency


  Resources are distributed to the goods and services that consumers want, maximising utility. Exists at P = MC, where consumers pay for the value of the marginal utility they derive.
• Productive efficiency


  Firms produce at the lowest point on the short run or long run average cost curve. MC = AC is a point of productive efficiency. All points on the PPF curve are productively efficient.
• Static efficiency


  Allocative and productive efficiency
• Dynamic efficiency


  All resources are allocated efficiently over time, and the rate of innovation is at the optimum level, leading to falling long run average costs. Consumer needs and wants are met as time goes on.
• Dynamic efficiency is affected by

  Short run factors such as demand, interest rates and past profitability
• 1. inefficiency


  A firm is producing within the AC boundary, so costs are higher than they would be with competition in the market.
• Characteristics of perfect competition

  • Many buyers and sellers
  • Sellers are price takers
  • Free entry to and exit from the market
  • Perfect knowledge
  • Homogeneous goods
  • Firms are short run profit maximisers
  • Factors of production are perfectly mobile
• In a competitive market, profits are likely to be lower than a market with only a few large firms


  Each firm has a very small market share, so their market power is very small. New firms will enter due to low barriers, increasing supply and lowering prices.
• Profit maximising equilibrium in the short run and long run

  In the short run, firms can make supernormal profits. In the long run, profits are competed away and only normal profits are made.
• Advantages of perfect competition

  • Lower price in the long run
  • P = MC, so allocative efficiency
  • Productive efficiency as firms produce at the bottom of the AC curve
  • Supernormal profits in the short run might increase dynamic efficiency through investment
• Disadvantages of perfect competition


  • Dynamic efficiency might be limited due to lack of supernormal profits
  • Firms are small, so few or no economies of scale
  • Assumptions rarely apply in real life, so competition is imperfect
• Characteristics of monopolistically competitive markets

  • Imperfect competition
  • Firms are short run profit maximisers
  • Firms sell non-homogeneous products due to branding
  • Many relatively close substitutes, so high XED
  • Large number of small, independent buyers and sellers
  • No barriers to entry or exit
  • Firms have some degree of price setting power
  • Imperfect information
• Profit maximising equilibrium in the short and long run

  In the short run, firms profit maximise at MC = MR, earning supernormal profits. In the long run, new firms enter, shifting the demand curve left, so only normal profits are made.
• Advantages of monopolistically competitive markets


  • Consumers get a wide variety of choice
  • The model is more realistic than perfect competition
• Disadvantages of monopolistically competitive markets

  • Allocative inefficiency in short and long run (P > MC)
  • Productive inefficiency as firms do not fully exploit factors, leading to excess capacity
  • Firms are not as efficient as in perfect competition, with x-inefficiency
  • Dynamic efficiency might be limited due to lack of supernormal profits
• Characteristics of an oligopoly


  • High barriers to entry and exit
  • High concentration ratio
  • Interdependence of firms
  • Product differentiation
• Concentration ratio


  The combined market share of the top few firms in a market. The higher the ratio, the less competitive the market.
• Reasons for collusive behaviour

  • Firms agree to work together, e.g. set price or output, to minimise competitive pressure and maximise profits
  • More likely where there are few firms, similar costs, high entry barriers, hard to be caught, ineffective competition policy, and consumer inertia
• Reasons for non-collusive behaviour

  • Firms compete, establishing a competitive oligopoly
  • More likely where there are several firms, one has a significant cost advantage, products are homogeneous, and the market is saturated
• Overt collusion


  Formal agreement between firms, often illegal
• Tacit collusion


  Implicit agreement between firms without formal communication
• Costs of collusion


  • Loss of consumer welfare from higher prices and lower output
  • Absence of competition reduces efficiency, increasing average costs
  • Reinforces monopoly power, making entry difficult
  • Lower quantity supplied leads to loss of allocative efficiency
• Benefits of collusion


  • Industry standards could improve, especially for technology
  • Excess profits could fund investment to improve long-run efficiency
  • Firms can exploit economies of scale by increasing size
• Cartel


  Group of firms that agree to control prices, limit output, or prevent new entry
• A cartel is a group of two or more firms which have agreed to control prices, limit output, or prevent the entrance of new firms into the market
• A famous example of a cartel is OPEC, which fixed their output of oil. This was possible since they controlled over 70% of the supply of oil in the world
• Cartels can lead to higher prices for consumers and restricted outputs
• Some cartels might involve dividing the market up, so firms agree not to compete in each other's markets
• Price leadership


  One firm changes their prices, and other firms follow. This firm is usually the dominant firm in the market
• Other firms are often forced into changing their prices too, otherwise they risk losing their market share
• This explains why there is price stability in an oligopoly; other firms risk losing market share if they do not follow the price change
• Price leader


  The firm judged to have the best knowledge of prevailing market conditions
• Game theory


  Used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm
• Prisoner's Dilemma


  A model based around two prisoners, who have the choice to either confess or deny a crime. The consequences of the choice depend on what the other prisoner chooses
• Dominant strategy


  The option which is best, regardless of what the other person chooses
• Nash equilibrium


  A concept in game theory which describes the optimal strategy for all players, whilst taking into account what opponents have chosen. They cannot improve their position given the choice of the other
• Even if both prisoners agree to deny, each one has an incentive to cheat and therefore confess, since this could reduce their potential sentence from 2 years to 1 year. This makes the Nash equilibrium unstable
• Price war


  A type of price competition, which involves firms constantly cutting their prices below that of its competitors
• Predatory pricing


  Illegal. Firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses
• Limit pricing


  Low prices discourage the entry of other firms, so there are low profits. It ensures the price of a good is below that which a new firm entering the market would be able to sustain