Topic 5 - Different Types of Markets and Competition

• Market structure


  How the market is organised
• Characteristics of market structures

  • Number of firms
  • Degree of product differentiation
  • Ease of entry into the market
• Perfectly competitive market


  • 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
• Profits in a competitive market

  Profits are likely to be lower than a market with only a few large firms
• Profit maximising equilibrium in the short run


  1. Firm produces output Q1

  2. Firm earns supernormal profits (shaded area)
• Profit maximising equilibrium in the long run

  1. New firms enter the market

  2. Supply increases, causing price to fall

  3. Firms only make normal profits in the long run
• Advantages of perfect competition

  • Lower price in the long run
  • Productive efficiency
  • Supernormal profits in the short run may increase dynamic efficiency
• Disadvantages of perfect competition


  • Limited dynamic efficiency in the long run
  • Few or no economies of scale
  • Assumptions rarely apply in real life
• Monopolistically competitive market


  • Imperfect competition
  • Firms sell non-homogeneous products due to branding
  • Large number of buyers and sellers
  • Firms compete using non-price competition
  • No barriers to entry or exit
  • Firms have some degree of price setting power
  • Buyers and sellers have imperfect information
• Profit maximising equilibrium in the short run


  1. Firm produces output where MC = MR

  2. Firm earns supernormal profits (shaded area)
• Profit maximising equilibrium in the long run

  1. New firms enter the market

  2. Demand curve shifts left

  3. Firms only make normal profits in the long run
• Advantages of monopolistic competition


  • Consumers get a wide variety of choice
  • Model is more realistic than perfect competition
  • Supernormal profits in the short run may increase dynamic efficiency
• Disadvantages of monopolistic competition


  • Allocative inefficiency in short and long run
  • Productive inefficiency due to excess capacity
  • X-inefficiency due to lack of incentive to minimise costs
• Oligopoly


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


  Firms agree to work together, e.g. set price or output, to minimise competition
• Non-collusive oligopoly


  Firms compete against each other
• Collusion is more likely when there are few firms, similar costs, high entry barriers, hard to be caught, ineffective competition policy, and consumer inertia
• Collusion can be overt (formal agreement) or tacit (unspoken agreement)
• Overt collusion is illegal in the EU, US and several other countries
• Non-collusive oligopoly is more likely when there are several firms, one firm has a significant cost advantage, products are homogeneous, and the market is saturated</b>
• Collusion


  Agreements made by firms to maximise their own benefits and restrict output, causing market price to increase. This deters new entrants and is anti-competitive.
• Factors making collusion more likely


  • Few firms
  • Similar costs
  • High entry barriers
  • Difficult to be caught
  • Ineffective competition policy
  • Consumer inertia
• Overt collusion


  Formal agreement made between firms. It is illegal in the EU, US and several other countries.
• Tacit collusion


  No formal agreement, but collusion is implied.
• Cooperation is allowed in the market, whilst collusion is not. Collusion is usually with poor intentions, whilst cooperation will be beneficial.
• Collusion generally refers to market variables, such as quantity produced, price per unit and marketing expenditure. Cooperation might refer to how a firm is organised and how production is managed.
• Kinked demand curve model


  Illustrates the feature of price stability in an oligopoly. It assumes other firms have an asymmetric reaction to a price change by another firm.
• If price increases from P1 to P3

  Other firms do not react, so the firm which increases their price loses a significant proportion of market share (Q1 to Q3)
• If the firm decreases their price from P1 to P2


  The firm only gains a relatively small increase in market share (Q1 to Q2)
• Cartel


  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.
• 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.
• Price war


  A type of price competition, which involves firms constantly cutting their prices below that of its competitors.
• Non-price competition


  • Aims to increase the loyalty to a brand, which makes demand for a good more price inelastic.
  • Examples: improved customer service, longer opening hours, special offers, advertising and marketing
• Barriers to entry


  Designed to prevent new firms entering the market profitably. This increases producer surplus.
• 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.
• 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.
• Disadvantages of oligopoly


  • Higher prices and profits and inefficiency may result in a misallocation of resources
  • Collusion could reinforce the monopoly power of existing firms and makes it hard for new firms to enter
  • Absence of competition means efficiency falls
• Advantages of oligopoly


  • Firms are more likely to innovate if they can protect their ideas
  • Industry standards could improve
  • Higher profits could be a source of government revenue