3.4

• Allocative Efficiency: When resources are allocated to maximise utility
• Productive Efficiency: When firms produce at the lowest average cost
• Dynamic Efficiency: Investment into resources being allocated efficiently in the long-run
• 1. X-inefficiency: When firms fail to reduce average costs at a specific output level
• Characteristics of perfect competition

  • Many buyers and sellers
  • Price takers
  • No barriers to entry or exit (low sunk costs)
  • Homogenous products
  • Perfect knowledge
• Profit maximising equilibrium in the short-run and long-run in perfect competition

  1. Price = MC

  2. Produce at Qpmax as MC = P so are allocatively efficient
• Firms have an incentive to enter the market in perfect competition

  Because of the short-run supernormal profit and low barriers to entry
• Characteristics of monopolistic competition


  • Many buyers and sellers
  • Price makers
  • Low barriers to entry and exit
  • Differentiated products
  • Imperfect information
• Profit maximising equilibrium in the short-run and long-run in monopolistic competition

  1. In the short-run, firms make a supernormal profit which incentivises firms to enter the market

  2. In the long-run, only normal profits can be made as products become more price elastic reducing average revenue (demand)
• Firms in monopolistic competition can try and make supernormal profits by innovating and further differentiating their products
• Characteristics of oligopoly

  • High barriers to entry and exit
  • High concentration ratio (5-firm concentration ratio <60%)
  • Interdependence of firms
  • Product differentiation
• Concentration ratio


  • The combined market share of the n firms in a market
  • The higher the concentration ratio, the market is less competitive
• Reasons for collusive and non-collusive behaviour

  • Collusive behaviour: Small number of firms, low threat of new entrants, similar costs, poor competitive policies from government
  • Non-collusive behaviour: Several firms, one firm has a cost advantage, homogenous products and a saturated market
• Overt collusion


  When a formal agreement is made between firms, it is illegal in the EU, US and more countries
• Tacit collusion


  When firms engage in collusive behaviour without a formal agreement
• Cartels

  A group of two or more firms agree to control prices, limit output and increase barriers to entry
• Price leadership


  One firm changes their prices and other firms follow. This may be forced in order to not lose market share
• Prisoner's dilemma


  A simple two firm/two outcome game theory model related to the concept of interdependence between firms
• Types of price competition

  • Price wars: Firms constantly cut their prices below competitor's prices
  • Predatory pricing: Firms set a low price to drive out firms in the market
  • Limit pricing: Firms price their goods low so that new firms are unable to compete and enter the market
• Types of non-price competition

  • Quality of goods and services
  • Convenience
  • Special offers
  • Loyalty schemes
  • Advertisement
• Characteristics of a monopoly

  • High barriers to entry
  • Price makers
  • Ability to price discriminate
  • Profit maximise (make supernormal profit)
  • One sole seller in the market (firm has 25% market share)
• Profit maximising equilibrium in a monopoly

  1. P > MC due to profit maximising, so there is allocative inefficiency

  2. AR < AC so there are supernormal profits
• Third degree price discrimination

  When a monopoly charges different groups of consumers (with different elasticities) different prices for the same good/service
• Costs and benefits of monopoly to firms, consumers, employees and suppliers

  • Consumers are exploited by higher prices leading to underconsumption and consumer's marginal utility not being met
  • High production costs as they have no incentive from competition to become more efficient
  • Consumers have a lack of choice
  • High supernormal profits which can be invested into being dynamically efficient, creating positive externalities and innovation
  • May be more efficient for only one firm to produce a good or service if there is a natural monopoly
  • Could generate export revenue
  • Economies of scale
  • Profits could be a source of tax revenue for the government
• Natural monopoly: When there are high fixed and sunk costs which are usually due to infrastructure, causing high barriers to entry
• Characteristics of a contestable market

  • Freedom of entry and exit
  • Threat of new entrants
  • Low sunk costs
• In a contestable market, prices and profits remain low