Unit 7 - Market Structures

A firm produces a differentiated product and earns supernormal profit in the long run. It produces where P>AC, AC>MC and AR>MR. It seeks to attract customers away from rival firms mainly by the use of free gifts and competitions. 1. Identify the market structure under which the firm is operating (theoretically anyway - see the notes on the previous pages). 2. Give one reason for each as to why it is not operating under any of the other three market structures.

1. Did you identify that this firm is operating under an oligopoly? 2. It is not perfect competition because the product is differentiated, the firm earns supernormal profit in the long run, it is a price-maker, it is not allocatively efficient, and it is not productively efficient in the long run. It is not monopolistic competition because supernormal profit is earned in the long run. It is not a pure monopoly because there are rival firms.

In 2004, sales of Dyson floor cleaners in the USA overtook those of Hoover. Dyson has been the UK's preferred brand of cleaner for some years. In 2008 Dyson's bagless cleaners had a 46 per cent share of the US market and a 32 per cent share of the UK market. James Dyson, the founder and head of the firm, continues to develop new cleaners, for instance by inventing a cleaner with a ball that can turn corners. Dyson has also developed other products, for example hand dryers and its latest invention, the Supersonic hair dryer. Dyson now produces a range of household appliances. In the 1990s Dyson moved the firm's production to Malaysia in a bid to reduce costs of production. Dyson considered the move was necessary because, although his firm was gaining market share at the expense of Hoover, it was still facing fierce competition from firms such as Miele. The pressure on a firm's costs in a particular economy is influenced by a number of factors. These include whether there is any spare capacity in an economy and the productivity of capital and labour. These, in turn, are influenced by advances in technology and training. As well as seeking to increase productive efficiency, firms try to be as allocatively efficient as possible. If all firms are productively and allocatively efficient, an economy will be Pareto efficient. 1. What evidence is there in the passage that Dyson is a dynamically efficient firm? (3 marks) 2. Explain how efficiency can enable a firm to gain a greater market share. (3 marks) 3. Describe how a firm can seek to become more allocatively efficient. (4 marks) 4. Explain the link between spare capacity and Pareto efficiency. (4 marks) 5. Assess whether more spending on training will increase productive efficiency. (7 marks)

1. Dynamic efficiency is efficiency achieved over time, as opposed to static efficiency which is achieved at the present moment only. Dyson has continued to invest and innovate to keep pace with changes in consumer demand, to raise the quality of its products and to develop its product range. 2. Efficiency can help a firm to achieve a greater market share because it keeps the costs down, allowing it to keep its prices competitive and to boost its demand and its sales at the expense of its competitors. 3. A firm can become more allocatively efficient by producing at the point where the benefit derived from the marginal unit equals the cost of producing that marginal unit. (This is a positive statement.) A firm should continue to produce additional units so that this condition applies, rather than restricting output in order to keep the price higher and to make supernormal profits. (This is a normative statement.) 4. Pareto efficiency happens when it is not possible in an economy to make someone better off without making someone else worse off. The relationship between this and spare capacity can be shown in the production possibility curve below. If an economy is operating at point A, there is spare capacity and it is possible to produce more of both education and of other products. Any point on the curve would be more efficient. Thus at the point of spare capacity, it is possible to increase output in each sector of the economy without making the other worse off; there is no Pareto efficiency at this point. So if Dyson uses some of its capacity to produce more hair dryers at the expense of floor cleaners, people who need to dry their hair after washing it are better off but those who need to clean their houses are worse off. On the other hand, if there are unused resources that can be used for making hair dryers, they can be produced without reducing the supply of floor cleaners. 5. Spending more on training the workforce will increase productive efficiency as people who have undergone training can do their work more quickly and accurately, thus producing more output within a given period of time. This reduces the average cost of production and the firm becomes more productively efficient. The U-shaped average cost curve falls to a lower point.

In August 2007, British Airways (BA) was fined £147m for conspiring to fix airfares with Virgin Atlantic. They were found to have discussed the amount they would charge their customers to cover increases in the price of fuel. These fuel surcharges were introduced in 2004, and over 18 months the two airlines colluded on the level and timing of increases in their charges. Virgin Atlantic avoided prosecution because it alerted the UK competition authorities to the illegal arrangement. 1. How might the fuel surcharges have differed in the absence of collusion? 2. Explain two reasons why collusion between firms may not last.

1. Fuel surcharges might have been lower without collusion. This is because the airlines might have sought to keep the surcharges as low as possible in order to gain a competitive advantage over their rivals. 2. One reason why collusion between firms may not last is, as in this example, a member of a cartel may break ranks and inform on other members if it suspects that an investigation by the authorities is about to occur and it can benefit by doing a deal to escape punishment. Another reason is that, if costs of production change, the price set by a cartel may cease to benefit all members. In such a case, some of the members may decide to leave the cartel in order to be able to charge a different price.

In the UK, the car market is split into half fleet (company cars) and half retail, but fleet buyers often pay 20 per cent less than retail customers. The same models of car also sell for more in the UK than in the rest of the EU. 1. What evidence is there that the car industry engages in price discrimination? 2. What does this information suggest about the comparative price elasticity of demand: a) for fleet and retail buyers? b) in the UK and the rest of the EU?

1. Price discrimination arises from the fact that different prices are charged to fleet buyers and retail buyers for the same cars and from the fact that higher prices are charged to UK buyers than to buyers in other parts of the EU. 2. In terms of comparative price elasticity of demand: a) As higher prices are charged to individual buyers, it suggests that demand for fleet cars is more price elastic than the demand for cars sold to individual customers. For this reason, firms buying a number of cars are able to secure a discount for bulk buying. b) Demand for cars in the UK appears to be less price elastic than demand for cars in the rest of the EU, as higher prices are charged in the UK. In the UK, public transport is seen as a less close substitute for car travel than in the rest of the EU.

In April 2016, the CMA became aware that some estate agents were making joint decisions to join OnTheMarket.com and to remove their presence on other competing portals. The CMA wrote an open letter to estate agents warning them not to make agreements with their rivals over the online portals they use. 1. Why do you think estate agents were making these joint decisions? 2. What type of agreement is going on here and why was the CMA keen to stop these agreements from happening?

1. Online advertising is very important to estate agents as many prospective customers use this method to research the market. The estate agents may have wanted to favour the online portals which they believed did better business or, worse, in which they had a financial interest. 2. This may break competition law. The number and identity of online portals used by estate agents is an aspect of competition between estate agents. The choice of portal should be made independently by each firm. Making a joint decision could be considered to be collusion.

Which market structure you think the following industries operate within? For the purposes of this activity, you should assume that something close to perfect competition exists in the real world. 1. Supermarkets 2. Car repair 3. Foreign exchange 4. Banking 5. Restaurants 6. The UK's national lottery

1. Supermarkets - oligopoly 2. Car repair - monopolistic competition 3. Foreign exchange - perfect competition (see below) 4. Banking - oligopoly 5. Restaurants - monopolistic competition 6. The UK's national lottery - monopoly Note that, although the foreign exchange market is probably the nearest real-world example we can find to illustrate perfect competition, it is not completely perfect. The product is certainly homogeneous but the quality of service, variety of currencies on offer and commission charges can vary considerably.

Complete Table 3.1 and then answer the questions that follow it. Remember: Average cost = total cost ÷ output Average revenue = total revenue ÷ output Marginal cost = Total cost from higher output - total cost from lower output Marginal revenue = Total revenue from higher output - total revenue from lower output 1. What evidence is there that the firm is operating under conditions of perfect competition? 2. What is the equilibrium output? 3. What is the optimum output, i.e. the output where productive efficiency is greatest? 4. What is the output where there is normal profit? 5. What are the firm's fixed costs?

1. The firm is producing under conditions of perfect competition as average and marginal revenue are equal and constant at £35. 2. The equilibrium output is 6 units, i.e. where MC = MR. 3. The optimum output is 5 units as this is where average cost is lowest. 4. The normal profit output is 2 units as this is where AC = AR. 5. The firm's fixed costs are £20, since this is the cost of producing zero output.

The UK's big four supermarket chains, Tesco, Asda, Sainsbury's and Morrisons, have been building up land banks over a number of years. This is a process whereby a company, such as a supermarket, buys up land and holds it undeveloped with a view to developing it at some time in the future and also to earning a capital gain on rises in land prices in the meantime. These supermarkets claim that they need to secure land for future development. Some economists, however, claim that they are buying up land just to leave it idle, often for years. Tesco, in particular, has a huge holding of undeveloped land that it may turn into supermarkets and convenience stores to add to its more than 2,000 outlets. If Tesco does use all its land bank to build new stores, its market share could increase to 45 per cent and its supernormal profit rise even higher. If supermarkets do sell off any of their land, they can dictate how it can or cannot be used in the future. Another barrier to entry that is connected with land for building is the costly planning regulations that have to be complied with. Among the other barriers to entry into and exit from the UK grocery market are the economies of scale enjoyed by the large supermarkets, consumer loyalty and high advertising expenditure. 1. Identify two ways in which the size of a firm could be measured. (2 marks) 2. Why might a firm want to enter the UK grocery market? (2 marks) 3. Explain how land banks act as a barrier to entry into the UK grocery market (4 marks) 4. Is high advertising expenditure a barrier to entry or a barrier to exit? Explain your answer. (6 marks) 5. Discuss whether the existence of high barriers to entry and exit ensures that large supermarkets earn supernormal profit. (6 marks)

1. The size of a firm could be measured in terms of either its sales or its market share. 2. A firm would want to enter the UK grocery market if it feels that there are supernormal profits being made by the incumbent firms which it can share in. 3. The building up of land banks by supermarkets acts as a barrier to entry to other firms because it effectively stops potential competitors from using the land. This is especially important if the land is a prime site where a new store might want to open, e.g. near to other stores. 4. High advertising expenditure by an incumbent firm would be a barrier to entry to possible challengers to the extent that the advertising is successful in creating and keeping loyal customers, who would not buy from the new firms. It could also be a barrier to exit for the firm which has made this expenditure as it would not want to leave the market without waiting to benefit from its advertising. 5. High barriers to entry to new firms would reduce the amount of competition in the market and make it more likely for an incumbent firm to earn supernormal profits, as it can keep its prices higher. But this does not ensure supernormal profit, as the ability to earn this depends on the degree of competition in the market from other large established incumbents. So each of the large supermarkets benefits from keeping out new firms, but each limits the profitability of the others.

In Witney, a market town in Oxfordshire, there are 25 pubs. All of them serve food, but the range of food on offer varies considerably from bar snacks to expensive three-course meals. A few of the pubs are open all day and some run darts and dominoes teams and hold evening quizzes. 1. What evidence is there that the pubs operate under conditions of monopolistic competition? 2. What additional information would be useful in reaching a firm conclusion that this market structure exists in Witney?

1. There are a relatively large number of pubs. They are producing slightly different services - differentiated by, for example, opening hours, food on offer and additional entertainment provided. 2. It would be useful to assess the level of long-run profits, the ease of entry into and exit from the market, and the influence the public houses have on price.

Which of the following are examples of barriers to entry in the machine tools industry? 1. Long-term employment contracts with skilled employees 2. Low start-up costs 3. An absence of patents 4. Experience in producing the products 5. Brand names 6. Lack of knowledge of the level of profits being earned in the market

1. This is a barrier to entry because long-term contracts tie skilled employees to existing firms so they are not available for potential competitors to employ. 2. Low start-up costs are not a barrier to entry. 3. An absence of patents is not a barrier to entry. 4. Experience by existing firms makes it harder for new firms to compete so this is a barrier to entry. 5. This is a barrier to entry because brand names result in consumer loyalty to already established firms. 6. Lack of knowledge of profits would deter new firms from entering a market and so acts as a barrier to entry.

Tenby is a seaside town in South-West Wales and caters for tourists. There are many guest houses which offer bed and breakfast at very similar prices, around £60 per night. This might be the nearest real-world example of a perfect market. The Savoy Hotel London is a luxury hotel which costs around £500 per night for bed and breakfast. It is not the only luxury hotel in London but it does have a degree of monopoly power. 1. Make a list of the characteristics which Tenby guest houses would have to exhibit in order for the guest house market to be a perfect one. (6 marks) 2. Discuss the extent to which the guest house market is perfect. (6 marks) 3. Explain how the Savoy Hotel is able to charge such a high price for bed and breakfast. (6 marks) 4. 'The difference in the price of bed and breakfast shows that a Tenby guest house is making a normal profit and the Savoy Hotel is making an abnormal profit.' Discuss whether or not this statement is likely to be true. (6 marks)

1. To be a perfect market, Tenby guest houses would have to exhibit the following characteristics: a very large number of guest houses; an identical product (service) offered by each; the same price for a night's bed and breakfast; perfect knowledge of prices and products by all customers and all guest houses; no time or transport cost for customers of finding the cheapest guest house; no barriers to entry to or exit from the market. 2. Tenby has a large number of guest houses, although the number is not infinite. The service offered by each is probably similar, but it cannot be identical as there will be differences in location, decorations of rooms, quality of breakfast and of personal service. The prices will be similar, but some guest houses might be able to charge a higher price for a sea view, for example. Customers do not have perfect knowledge of the market and some may book in one guest house without knowing that another similar one is cheaper; it would take them time to research the market. There is a cost barrier to new guest houses entering the market. So the market is very competitive but probably not perfectly so. 3. The Savoy Hotel can charge a very high price for an overnight stay because the quality of its service is very high but, in addition, it is a well-known and up-market name and high-income people would like to stay there. Although there are other high-class hotels in London, the Savoy's brand makes it unique and the demand for its rooms is relatively very inelastic. It has a monopoly over its brand. 4. The nearer a market is to perfect competition, the more likely it is that all firms are earning normal, or near-normal, profit; by contrast, the more of a monopoly a firm is, the more likely it is to be able to earn a supernormal profit. So the statement could be true. However, the difference in the prices charged does not necessarily lead to the same conclusion. Although Tenby guest houses charge less than the Savoy, their costs are also lower and their profit margins could be high.

McArthur Glen Designer Outlet in Bridgend, South Wales, is a shopping centre which houses around 90 brands, many of which are clothing stores and which are located very close to each other. They compete in a variety of ways including on price, special offers and advertising. Each year the designer outlet witnesses the entry of new shops and the closure of others. 1. Why do you think clothing stores tend to locate close to one another? 2. What is the link between firms entering and leaving a market and efficiency?

1. You probably noted that clothing stores tend to locate close together as they know that consumers will gather there. If their windows display attractive offers, they may be able to attract consumers away from their rivals. This is an example of an external economy of scale, which you studied in Section 6 Topic 4. 2. If firms are able to enter and leave an industry easily, this should put pressure on firms in the industry to be efficient. This is because they know that if they are not efficient they will be driven out of the industry, in part by new and more efficient firms entering the industry to replace them.

Types of non-price competition

As mentioned above, non-price competition is common under oligopoly. In many oligopolistic markets, including retail banks, newspapers, TV companies, supermarket chains and car producers, the main forms of competition are advertising, brand names, free gifts, competitions and sponsorships. In oligopolistic markets where the customers are businesses, for example the supply of raw building materials such as cement, competition mainly takes the form of differences in service and credit arrangements for customers. Using marketing techniques to distinguish a product can mean that many differences between products are more perceived than real. Worse, marketing can lead to product and pricing complexity which consumers find hard to understand. This happens particularly in the service sector, for financial products, electricity, telephone, etc. A firm may break its product down into parts and reassemble these parts in various ways so as to offer different 'schemes' or 'plans', each with its own pricing structure. Because customers often do not understand what they are receiving and paying, they may in effect be buying something they do not want and paying more for it. A personal current account at a bank used to be a fairly simple product. Essentially it is a service whereby a customer deposits money regularly and uses the account to make payments in various ways. It also allows some customers to become temporarily overdrawn. However, in recent years banks have competed in this market by developing a range of current accounts, each with different features, to suit different people. At the time of writing (June 2016) Lloyds Bank offers 10 different types of current account on its website. Some of these accounts pay interest on credit balances, others do not. Accounts also offer different overdraft arrangements. Some make exclusive offers on other Lloyds products and some have 'add-ons', i.e. additional benefits such as travel insurance or cinema tickets. Different accounts are clearly aimed at different market segments, e.g. higher income customers, older people, students and Muslims; the last is because Islamic law prohibits the charging and payment of interest. Some of these accounts are free and others make a charge. The result for customers is that choosing a current account is a complicated business and it is hard for someone to calculate whether the add-ons provided are worth the extra fee paid. Some add-ons would be unnecessary for some customers: someone who already has an annual travel insurance policy does not need travel insurance as an add-on, for example. And the more complex the account, the less likely a customer might be to switch to an account with another bank, and this is what the bank wants. Firms may also compete through innovation. This is very much the case in the mobile phone market. Each producer spends huge amounts of money on research and development in order to enhance its product. The modern smartphone is the result of this innovation, each having features such as a camera and apps which were originally groundbreaking but which have become standard. One of the more recent developments is the ability to use a mobile phone to access a bank account. Each firm is constantly trying to find something different to make its own product stand out from those of other firms. Innovation is happening so quickly nowadays, and there are so many technical experts who can drive it, that any firm which succeeds in differentiating its brand from others by means of a new app or other enhancement knows that its advantage will be short-lived and that other firms will soon copy it. Another way of approaching non-price competition is a situation where a firm does not try to compete in the whole market but instead aims its product at a particular sector of the market, known as a market niche. For example, a shoe producer may concentrate on making shoes for people with very small and/or very big feet. This is called positioning.

Barriers to exit

As we have seen, barriers to exit are factors which make it difficult for a firm to leave a market and to stop producing a product. The main factors are as follows: - Long-term contracts -If, for instance, a firm has signed a contract to provide a product for a year on a continuous basis, it may be sued should it seek to exit the market before that time. (This assumes that the firm does not become bankrupt.) - Sunk costs - As you saw in Unit 6 Topic 4, these are costs incurred when a firm is set up or moves into a new market which cannot be recouped if the firm leaves the market. Examples of sunk costs are advertising expenditure, firm-specific equipment, uniforms and other materials. Somewhat paradoxically, barriers to exit can also act as barriers to entry. This is because some firms may be discouraged from entering a market which would be difficult to leave if profitability falls.

Collusion

As we saw above, the few large firms in an oligopoly market know a lot about each other and are constantly trying to second-guess each other's actions. To reduce uncertainty, firms may get together and engage in collusion. Cambridge Dictionaries Online defines collusion as follows: 'An agreement between people to act secretly or illegally in order to deceive or cheat someone.' Clearly collusion is not an ethical practice. If large firms were to collude with each other, it would be in order to deter new entrants to the market and to maximise joint profits. This collusion can take one of two main forms - overt collusion or tacit collusion. And we will look at these over the next few pages.

Non-collusive behaviour

Firms may decide to gain a greater share of the market by cutting price without making an explicit or implicit agreement with the other firms in the market. This may result in a price war, with rival firms responding to the price cuts by cutting their own prices. Recent years have witnessed a number of price wars, including those between the major supermarkets and between national newspapers. A price war is a high-risk strategy. If a firm has lower costs or more reserves, it may be able to eliminate some of its competitors but may itself be forced out of the industry.

Monopoly

Monopoly is the other end of the competition spectrum. Whereas a perfect market has an infinite amount of competition, a monopoly has absolutely none. There is just one firm supplying the whole market for the product and it is a price-maker rather than a price-taker. This firm is able to erect high barriers to entry so that it is impossible for other firms to enter the market.

Natural monopoly

Natural monopoly refers to a situation where there are strong reasons for a market to be dominated by one firm. This is usually a market where there are very high fixed costs, often involving large-scale and very expensive infrastructure. Examples of natural monopolies can be found in the area of public utilities such as the supply of water, electricity or gas. For example, an electricity distributor needs to set up the capital equipment involved in a national grid, such as pylons, cables and computerised distribution systems; a telecommunications supplier must provide satellites, masts and, again, high-tech computerised equipment. In order to set up this type of system, a firm must have access to vast amounts of finance and must be able to guarantee a large enough market share to enable it to cover its costs. Competitors would be discouraged because they would have to set up similar infrastructure systems and there would be duplication. Even if some equipment were shared, the incumbent firm would benefit from huge economies of scale. This would mean that the minimum efficient scale would be very large - this is the lowest level of output at which all economies of scale are fully exploited. However strong the practical reasons are for a market to be dominated by one firm, the lack of competition can still be a problem for consumers. If the prices are high or the quality of service bad, there is no alternative to switch to; and, in the case of essential services, customers do not have the option of not consuming the product. It is for this reason that natural monopolies are generally either owned and run by the public sector (i.e. nationalised) or are heavily regulated. There are other reasons for running natural monopolies under the public sector. It may be because the service being provided is an essential one but the business is not profitable. Or it could be the ethical argument that public services should be provided at an allocatively efficient price; if this price resulted in the firm making a loss, the private sector would not provide the service and it would be left to a state-owned natural monopoly. Railways are an example of this - see the box below. The trend in the UK over the last few decades has been to privatise public corporations, and electricity, gas, water and the railways have been returned to the private sector. Each industry is overseen by a special regulator: Ofgem is the energy regulator and Ofcom is the telecoms and media regulator. These bodies can intervene to cap prices and to address issues arising from service provision. The railway industry in the UK has been through many changes over the last 70 years. In 1948, the private railway companies were nationalised to form British Railways. During the period 1994-7, railway operations were privatised but were split. Ownership of the infrastructure (track, signals and stations) went to Railtrack but the actual train operations were franchised to individual private sector companies such as First, Virgin and Arriva. Railtrack collapsed and was replaced by Network Rail, an arm's length central government body; this means that the government does not take a direct role in managing the firm. Thus, although attempts have been made to run the railway sector in the private sector, the difficulty of making a profit has meant that the company providing the infrastructure has reverted to the public sector, although the individual train companies are private and compete with each other to some extent.

Which of the following events would increase market concentration? a) A horizontal merger b) An increase in access to raw materials c) A patent elapsing d) A reduction in average costs e) A reduction in barriers to exit

The answer is (a). A horizontal merger will reduce the number of firms in the market and so increase market concentration. (b), (c), (d) and (e) would all make it easier for new firms to enter the market and so reduce market concentration.

Which is an example of collusion? a) bid rigging b) game theory c) non-price competition d) price discrimination

The answer is (a). Bid rigging is collusion as it is an agreement between parties to a tender to keep the price high.

A study on the sales in an industry found a three-firm market concentration ratio of 62 per cent. What does this mean? a) The three largest firms accounted for 62 per cent of that industry's exports b) The three largest firms accounted for 62 per cent of profits earned c) The three largest firms concentrated 62 per cent of their sales in the home market d) The remaining firms accounted for 38 per cent of employment e) The remaining firms accounted for 38 per cent of sales

The answer is (e). A three-firm market concentration ratio of 62 per cent based on sales means that the three largest firms account for 62 per cent of sales and the remaining firms in the market therefore account for 38 per cent of sales.

The following information is known about a firm's costs and revenue: marginal cost = £6 average cost = £6 marginal revenue = £6 average revenue = £6. Which of the following market structures is consistent with this information? a) monopoly b) monopoly and oligopoly c) oligopoly d) monopolistic competition e) perfect competition

The answer is (e). It is only under conditions of perfect competition that average revenue equals marginal revenue. In the other market structures, firms are price-makers and so average revenue exceeds marginal revenue.

Topic 1 - Productive and allocative efficiency

The revenue a firm earns and the costs it incurs are influenced by how efficient it is. In this topic you will explore the different types of efficiency and how the level of competition in a market may influence efficiency.

Summary of Productive and allocative efficiency

This topic has focused on the nature of efficiency and why a high level of competition may promote efficiency. The key points are as follows: - Productive efficiency is concerned with cost. It is achieved at the lowest point on the lowest average cost curve. - Allocative efficiency is concerned with the quantity produced. It occurs when the right products are produced in the right quantities to satisfy customers' wants. - Pareto efficiency is difficult to achieve and would mean that all industries have to be both productively and allocatively efficient. - X-inefficiency will occur if, due to a lack of competition, firms become complacent and allow average cost to rise. - To be dynamically efficient, firms must invest and innovate. - Competition provides both a carrot, in the form of profit, and a stick, in the form of bankruptcy, for firms to be efficient.

X-inefficiency

X-inefficiency, also sometimes referred to as organisational slack, occurs when firms lack the competitive pressure to produce at the lowest possible average cost. There is said to be X-inefficiency when the actual average cost curve is higher than the average cost curve which could be attained with maximum efficiency. This situation is shown in Figure 1.4. X-inefficiency can arise from a number of causes: firms may not seek out the cheapest raw materials, managers may be paid over-generous bonuses or given excessive fringe benefits, or the firm may not be making best use of its workers' talents.

The n-firm concentration ratio

You have seen that an oligopoly is a situation where 'a few' firms control a large percentage of the market, but this is quite a general statement and we need to specify the situation more closely in the case of any particular market. To do this, we use the n-firm concentration ratio. The symbol 'n' is used in mathematics to denote an indefinite number, i.e. a number we do not know. Here, 'n' stands for the number of firms accounting for a large share of a market. This might be anything from two firms to five or six. So the three-firm concentration ratio would measure the percentage market share of the three biggest firms, the four-firm ratio the percentage market share of the four largest firms, etc. As we saw in Topic 2, market share can be measured in terms of sales, output or employment. The Competition and Markets Authority considers that a firm might have a 'dominant position in the market if it has more than a 40% market share and is not affected by normal competitive restraints'.

Which output would ensure allocative efficiency? a) Average cost equals marginal cost b) Average cost equals marginal revenue c) Average revenue equals marginal revenue d) Price equals marginal cost e) Price equals average cost

You probably found this a relatively straightforward question. The correct answer is (d). Allocative efficiency is achieved where P = MC.

Which of the following is evidence of X-inefficiency? a) A firm employing more staff than needed b) A firm reducing excessive levels of stocks c) A firm raising the pay of top-performing executives because profits have risen d) A firm switching resources from a product declining in demand to one increasing in demand e) A firm receiving a larger discount from a supplier as a result of increasing the size of its order

You should have picked answer (a). X-inefficiency results in average cost being lower. Over-manning would mean that labour costs are higher than necessary. Answers (b) and (e) would cut costs and result in the firm becoming more efficient. (c) may increase a firm's revenue and may cut its average costs if the top-performing executives increase the profitability of the firm. (d) would raise the firm's revenue and increase allocative efficiency.

Which is NOT usually a feature of an oligopolistic market? a) high barriers to entry b) high market concentration c) interdependence between firms d) price competition

You should have written (d). Firms in an oligopoly do not normally engage in price competition. Each firm decides not to raise its price as it expects that other firms will not follow suit, and not to lower its price as it expects that other firms will follow suit.

Sources of monopoly power

-Barriers to entry: Monopolies can arise and exist because they are able to erect barriers to entry to potential competitors. We have already studied these barriers in Topic 2 where you saw that they include unique access to factors of production, a unique product, economies of scale and patents and copyrights. There is also the case of the state-owned natural monopoly; we consider this in a later section. For the time being, we are concerned with how a monopoly behaves in a private sector profit-maximising context. -Integration: A monopoly can be the result of a horizontal merger or the takeover of one firm in the industry by another. If an industry consists of two large firms and they then merge, there will be one monopolist left to supply the market. In May 2016, the European Commission blocked the proposed sale of the mobile phone company O2 by its Spanish owner Telefonica to CK Hutchison, the company which owns the mobile phone company Three. The deal was worth £10.3bn and would have meant that the UK would have only three major mobile phone network operators. The European Commission was afraid that, if the sale had gone ahead, customers would have had less choice and prices would have been raised. -Product differentiation: Product differentiation means that a firm makes sure that its own brand of a product is unique because of its special features and design. The more a firm can make its product distinctive, the more it can create a monopoly in that product. Indeed, if the brand's name becomes the generic name for the product, the firm will have considerable market power. Examples are Hoover (vacuum cleaners) and Google (search engine). We will be looking more closely at product differentiation in Topic 4 on monopolistic competition. Strictly speaking, every firm has a monopoly in its own brand, although this does not mean that it has a monopoly of the whole market. For example Hotpoint has a monopoly on Hotpoint electrical goods but not of the electrical goods industry. But if enough consumers like Hotpoint goods so much that they always choose them in preference to, for example, Indesit products, then Hotpoint has some monopoly power over those consumers as their demand is highly inelastic. Economic analysis assumes that a monopolist controls 100% of the industry, defined widely, even though it is hard to find an industry where there is only one firm and absolutely no competitors. It is also worth noting that even a firm in such a position has a monopoly only within its own market; it still faces competition from firms producing other types of product. This is because all firms are competing for consumers' limited incomes. So even if Hotpoint controlled 100% of the electrical goods market, it would still be in competition with firms supplying package holidays or with carpet manufacturers since someone who spends their last savings on a new carpet would not be able to afford a new washing machine. (Note that the concept of opportunity cost comes in here.) Although economic theory defines a monopoly market as one with a single supplier, the word is used more loosely in everyday economic language. A firm which has acquired a large market share is sometimes said to have a degree of 'monopoly power', although it will almost certainly have competitors. In the UK, a firm is said to have a significant degree of monopoly power when it has 25% or more of the market. Monopoly can also be defined in terms of time and space. For example, the coffee shop on a train has a monopoly during the course of a journey, although people could buy food and drinks before boarding. And a cinema which is the only one in a town has a monopoly within that town, although people might go to a cinema in a neighbouring town or could even stay at home and watch a streamed movie.

Every year in the weeks leading up to Easter, supermarkets buy large stocks of Easter eggs. A few supermarkets sell out of Easter eggs before Easter but most end up selling off some Easter eggs at much reduced prices just after Easter. 1. Explain why devoting more shelf space to Easter eggs before Easter is evidence of allocative efficiency. 2. Comment on whether the sell-off of Easter eggs after Easter is evidence of allocative inefficiency before Easter.

1. Buying more stocks of Easter eggs in the run-up to Easter is evidence suggestive of allocative efficiency as it is an action designed to respond to a change in consumer demand. At Easter, people want to buy Easter eggs, and the supermarkets respond by supplying them. 2. It appears that the sale of Easter eggs after Easter at a reduced price is evidence suggestive of previous allocative inefficiency. This is because the sale results from a surplus of initially unsold stock - more Easter eggs were supplied at the original price than were demanded. It is, however, difficult in practice to supply exactly the correct amount. Supermarkets would probably prefer to supply too many Easter eggs than have unsatisfied customers. It may also be argued that the sale of cheap Easter eggs attracts people into the supermarkets who will then buy a range of other products.

UK supermarket chains have been accused of abusing their buying power. Critics have accused them of bullying small farmers into accepting low prices for their produce. It has also been claimed that they often pay their suppliers late and pass on costs of transporting and packaging to them. 1. What is meant by buying power? 2. Why may small farmers accept low prices from supermarkets? 3. What may motivate the supermarkets to behave in the ways outlined above?

1. Buying power is the ability to determine the price paid for a good or service. 2. Small farmers may be forced to accept low prices from the supermarkets because the supermarkets buy so much of their produce. If the small farmers were to reject the prices offered by the supermarkets, it is unlikely that they would be able to sell as much to smaller retailers and/or in farm shops. 3. Supermarkets try to drive down the price they pay their suppliers in order to lower their costs and increase their profits.

Tacit collusion

'Tacit' means 'unspoken' and so tacit collusion takes place without the firms actually making any express or formal agreement. The most common form of tacit collusion is price leadership. The price leader in a market is the firm which makes policy moves first and which other firms follow. It is usually the biggest firm in the market, and less powerful competitor firms often have little choice but to follow its actions and match its prices, otherwise they may lose their market share. There may be a dominant price leader in a market, which is always the price leader because of its size and market share. The dominant firm either increases or decreases its price first and other firms follow suit. Alternatively, there may be a barometric price leader situation, where no one firm is dominant and where the price leadership may change over time. Remember that the firms are vying for the best position in the market. One may try out a price change (in either direction) and then wait to see what the other firms do. If they believe that the market situation justifies the price change, they will follow suit; if not, they will keep their prices steady and the first firm may return to this price level.

Check your understanding of the characteristics of a perfect market by comparing them with what happens in real-world markets. Give an example in each case. Real-world markets are different from the perfect competition model in that: - Real-world markets are dominated by a few large firms, e.g. supermarkets and retail banks. - ......... etc. Write the remaining characteristics.

- Products are highly differentiated, e.g. mobile phones. - There is strong price competition, e.g. hotels. - Consumers have imperfect knowledge, e.g. domestic fuel tariffs. - There are time and transport costs of finding the cheapest products, e.g. supermarket products. - There are barriers to entry, e.g. airlines.

There are relatively low barriers to entry into and exit from the road haulage industry. A new firm could lease one or two vehicles and advertise locally. Customers tend not to mind which firms' vehicles they use to transport their goods. All firms in the industry have to prove that their vehicles are roadworthy, and all have to employ qualified drivers. 1. Identify a barrier to entry that exists in the road haulage industry. 2. Explain one reason why barriers to entry may harm consumers and one reason why they may benefit consumers.

1. A barrier to entry is the need to use roadworthy vehicles. This means that new entrants must spend money on having their vehicles tested and on maintaining them, but this is a relatively low barrier to entry. 2. Barriers to entry may harm consumers because the firms in the market may drive up prices to earn supernormal profits, knowing that prices will not be driven down by new firms entering the market. Some barriers to entry, however, may protect consumers. Such barriers include the need to meet health and safety standards, to prove that their vehicles are roadworthy, and to hire qualified staff.

Game theory is being increasingly used by large firms in working out their business strategies. They use it to work out how to prevent new firms entering the market, how to deal with any firms that do manage to overcome the barriers to entry and exit, how to prevent hostile takeovers and how to respond to the strategies of rival firms. In some cases, game theory may suggest they should cooperate with their rivals to avoid a price war, since engaging in a price war is a high-risk strategy. In markets dominated by a few large firms, however, price wars do occasionally break out, or at least appear to break out. In February 2009 Asda, Britain's second largest supermarket chain, announced that it would cut 5000 prices in addition to the 7500 price cuts it had announced in January 2009. The rival supermarkets responded by lowering the prices of some of their products. For instance, Tesco cut the price of 300 frozen food items. The big four supermarkets released a number of price comparison adverts at the start of 2009. These resulted in a number of complaints to the Advertising Standards Authority, the regulator. People complained that the adverts made exaggerated claims and were unclear. Some critics also claimed that the supermarkets deliberately raised prices in order that they could then cut them or provide BOGOFs (buy one, get one free). It has also been suggested that the supermarkets fix the price of some products together. Indeed, in 2007 the big four supermarkets were investigated on suspicion of fixing the price of milk, butter and cheese. Such price fixing reduces consumer surplus and restricts the competitive process. 1. What is meant by a price war? (2 marks) 2. Explain why a price war may be a 'high-risk strategy'. (5 marks) 3. Which type of market structure is 'dominated by a few large firms'? (1 mark) 4. Identify two other characteristics of this market structure (2 marks) 5. Explain what is meant by 'price fixing reduces consumer surplus and restricts the competitive process'. (3 marks) 6. Discuss whether consumers would have benefited from the price cuts made by the big few supermarkets in January and February 2009. (7 marks)

1. A price war is a situation where competitor firms continually cut their prices until one is forced out of business and the survivor remains, only to raise its prices again. 2. A price war is a high-risk strategy because each firm is in danger of being forced to cut its prices to a level at which it is making a loss. If it does not have sufficient reserves to finance itself through this period, it could go out of business. It is hard for an individual supermarket not to follow suit when its rivals are cutting prices because people have quite good knowledge of price differences and not all customers are loyal; they will shop at the supermarket where the prices are lower. 3. A market which is dominated by a few large firms is called an oligopoly. 4. Two other characteristics of this market structure are that the firms engage in non-price competition but not in price competition; and that they often practise collusion, although this is illegal. 5. A consumer surplus is the difference between the price paid by a consumer and the price the consumer would have been willing to pay. Price fixing by supermarkets keeps prices artificially high and so consumers are paying more for their shopping. The difference between these prices and the prices they would have been willing to pay is now smaller. Price fixing restricts a firm's ability to compete by reducing its prices. 6. Some consumers probably did benefit from some price cuts, especially if they shopped around. But it is unlikely that each supermarket cut the prices of all its products so each consumer probably paid more for certain products to compensate the store for the lines where it had cut the price. Researching to find out the supermarket at which each product is cheaper would be very expensive for consumers in terms of time and money. It is also doubtful whether consumers would have benefitted in the long-run as the price cuts would have been temporary. When the market had settled, the supermarkets would have adjusted their price lists. (7 marks)

In 2008 XL Leisure, the UK's third largest package tour operator, went out of business. It is unusual for such a large tour operator to go bust, although each year some firms will be replaced by others hoping to establish themselves in the market. 1. What effect would the exit of XL Leisure from the tour operator market have on the market concentration ratio? 2. What encourages new firms to enter a market? 3. What effect will the entry of new firms into a market have on the market concentration ratio?

1. Hopefully you spotted that the effect of the exit of XL Leisure on the market concentration ratio would depend on how the business lost was shared out among its rivals. If its business went to its large rivals, the market concentration ratio may not change much. However, if the business was more widely dispersed among its smaller rivals, the market concentration ratio would decline. 2. New firms are attracted into a market by the prospect of earning supernormal profit. 3. The entry of new firms into a market should reduce the market concentration ratio, but again it depends on the size of the new firm and the extent to which it is able to take customers away from incumbent firms. For example, the entry of large supermarkets such as Aldi and Lidl has significantly reduced the market shares of the big four UK supermarkets, but the entry of a niche food retailer would not affect the large stores much, although it could take market share from other small firms.

In November 2015, Lloyds Bank announced it would be cutting up to 1000 jobs as part of its three-year strategy of cutting 9000 jobs and closing 200 branches. This cost-cutting decision will reduce the amount of duplication of roles and of service provision. 1. Explain why duplication in roles among staff would lead to productive inefficiency. 2. Why might dismissing some workers who are duplicating roles raise unit labour costs?

1. If there is duplication of roles, it suggests that Lloyds is employing more workers and operating more branches than necessary and so it is not minimising its average costs. 2. There is a chance that making some workers redundant may reduce the morale and productivity of the remaining staff. It may also make it more difficult to cover for staff away from work as a result of illness or attending training courses.

During the Wimbledon tennis championships more taxi firms move into the area in search of fares from both participants in the tournament and spectators. At the end of the championships, the taxis return to their normal routes. 1. Explain why more taxi firms moving into the Wimbledon area during the tournament is an example of hit-and-run competition. 2. Explain how one group of people may be adversely affected by the competition from the taxi firms new to the area. 3. Identify two benefits which taxi passengers may gain from the competition generated by the increase in the number of taxi firms servicing the area.

1. More taxi firms moving into the Wimbledon area is an example of firms entering a market during periods of rising demand to take advantage of a profitable opportunity but then leaving it when demand returns to the usual level. 2. One group of people who will not welcome the competition from the taxi firms entering the market are the incumbent taxi firms. The increased competition they will face means that they will not gain such high profits from the higher demand. 3. Taxi passengers are likely to find it easier to hire taxis than would be the case if the number of taxi firms in the local market did not increase.

Firms in the pharmaceutical industry develop, produce and sell medicines. Some of these medicines are branded and some are generic. Almost half of all pills and potions are sold in the US and the UK. The next two largest markets are the EU and Japan. Patents are a key feature of the market. These patents grant exclusive rights, usually for about 20 years. This involves the development of prescription drugs, working out correct doses, carrying out clinical trials and getting approval from government authorities to sell them. Patent protection allows firms to recover the high costs involved in getting drugs from development to market. When patent protection ends, a generic drug is often developed. This may be sold by rival firms although the firm making the brand drug will have a head start in the generic market. As generic drugs are cheaper to develop, test and gain approval for, they can be sold at relatively low prices. In 2009, 35 top branded drugs worth $55bn went off patent. The global pharmaceutical market contains some very large and profitable firms. In 2006 GlaxoSmithKline, a UK firm, made a profit of $10 135m, employed 106 000 people, and was ranked fourth in the world in terms of revenue and second in terms of market share. Large pharmaceutical firms spend considerable sums developing and marketing their products. In the last two decades, however, the nature of the pharmaceutical market has been changing. Advances in biotechnology are enabling firms to focus on more personalised medicines, for example a drug aimed at women suffering from a particular type of breast cancer. This means that pharmaceutical firms can operate on a smaller scale. Indeed, it is thought that, in some cases, small research and development departments can work well in biotechnology as they promote entrepreneurial spirit. The market has also become more vertically disintegrated. Traditionally, pharmaceutical firms have done everything from research through to manufacturing and then sales and distribution. In more recent years, however, some firms have been set up which concentrate on only one aspect of the process - developing drugs. In addition, consumers are now better informed and are making use of the internet to buy medicines directly. Mergers and takeovers are still occurring in the industry. For example, the US drugs giant Pfizer agreed a deal to buy Allergan, the maker of Botox, for $160bn (£106bn) in what is the biggest pharmaceuticals deal in history. In addition, the large firms have been accused of using a variety of anti-competitive practices. For instance, in 2009 the Swiss firm Novartis paid Dr Reddy's, an Indian firm, to delay the launch of a generic rival to Exelon, its Alzheimer's drug. Generic medicines are sold at a lower price than branded medicines. 1. Does this make them less profitable. Explain your answer. (3 marks) 2. Explain what is meant by an industry becoming 'more vertically disintegrated'. (3 marks) 3. What is meant by 'anti-competitive practices'? (2 marks) 4. Explain two anti-competitive practices that a large pharmaceutical firm may engage in. (4 marks) 5. Discuss, on the basis of the information in the passage, whether the pharmaceutical market is contestable. (8 marks)

1. No. Generic medicines can be sold at a lower price because, if they are produced by a company which did not develop them, it has not had to pay the costs of research and development, which can be very high over a long period. Even if the company had to pay for a licence to produce the medicines, the costs could still be much lower. So the original company which discovered the drug has to charge a higher price in order to cover its long-term costs. 2. Vertical disintegration means that, whereas large merged firms in an industry used to include all the stages of production, this has now broken up and different firms specialise in different stages. For example, one firm might specialise in developing medicines for a particular disease, or in research, or in production. 3. Anti-competitive practices are any unfair policies which a firm uses in order to make it harder for other firms to compete with it and which reduces the amount of competition in the market so that consumers are disadvantaged. 4. One example of an anti-competitive practice is bribing a rival firm to delay the introduction of a rival product. This means that a product which is possibly better and cheaper is not made available. Another such practice would be restricting employees from working for a competitor firm. 5. The pharmaceutical market is contestable to the extent that it is now possible for smaller firms to open up and compete, for example in biotechnology. There would be lower barriers to entry in niche parts of the market. In addition, vertical disintegration is breaking up large conglomerates and allowing smaller firms to enter the market. However, some drugs firms are very large indeed and they continue to merge and become bigger; this makes it harder for new smaller firms to start up. The market for mass-produced drugs is probably less contestable, but that for more specialist products may be more contestable.

The airline market has a number of barriers to entry. These include high advertising expenditure, established contacts between travel agents and incumbent airlines, and brand loyalty. Another barrier to entry is the need to obtain take-off and landing slots. This is particularly a problem at Heathrow Airport where demand for such slots exceeds supply. (Note that airlines do not usually purchase their aircraft but lease them, so the large amount of money needed to buy an aeroplane is not usually a barrier). Despite these barriers, a number of new firms have been able to enter the market in the last couple of decades. 1. Explain two factors that may have helped new firms enter the market. 2. What effect has the entry of new firms had on air fares?

1. One factor helping new firms is the increase in the number of people who book flights themselves online rather than booking through a travel agent. This means that the established connections between travel agents and airlines are becoming less important. Another factor is that more take-off and landing slots have become available with the growth in regional airports such as Luton and Exeter. 2. Air fares have fallen on a number of routes. The increased competition from what are largely low-cost airlines has provided more choice and driven down prices. Customers tend not to have much brand loyalty to airlines but usually choose the cheapest tickets, so this makes it easier for budget entrants to secure a market.

Sales of world travel guides fell by 23 per cent in the UK in the first eight weeks of 2009 compared with the same period a year before. It was expected that sales would decline further later in the year as fewer people were travelling abroad during the recession. Books covering more obscure destinations were particularly badly hit, as those who were holidaying abroad selected better-known cheaper foreign holiday resorts. At the same time, sales of travel literature books increased, as people who could not afford to travel could at least read about it. A few retailers quickly adjusted their stock, giving less space to travel guides and more to travel literature, but most were slow to react. A number of specialist publishers were facing bankruptcy and even some of the larger publishers, particularly those exhibiting signs of X-inefficiency, were experiencing difficulties. 1. From the information given above, were retailers of travel guides exhibiting allocative or productive inefficiency? Explain your answer. 2. How can major book publishers try to reduce costs to minimise X-inefficiency?

1. You should have noted that most retailers were allocatively inefficient. This is because they were not adjusting their stock quickly enough in response to changes in consumer demand. 2. Major publishers with large print runs can try to achieve the lowest possible printing costs by seeking new suppliers. They can also urge their staff to contain costs, for example by restricting the hospitality offered to potential and actual authors.

Efficiency

A dictionary definition of efficiency is 'achieving an objective with the least waste of time and effort'. But economists explore efficiency in more depth and identify several different concepts of efficiency. In this topic we will be looking at productive, allocative and dynamic efficiency and also at X-inefficiency. You need to be able to distinguish between these and also to look at efficiency and inefficiency in different market structures; this last point will be covered in later topics as we consider each market structure in turn.

Market concentration

A market is said to be highly concentrated when a few firms account for most of the activity in the market. The most concentrated market is one in which there is only one firm operating; this is called a monopoly, as we shall see in Topic 3. At the other end of the scale, if the market is shared between a high number of similarly-sized firms it is said to exhibit a low degree of market concentration. Economists use a number of measures of market concentration; here are three: - The best-known measure is the percentage of sales accounted for by the largest firms in the market. This is known as market share. For example, a five-firm market concentration ratio of 85 per cent would mean that the five largest firms have sold 85 per cent of all products sold in a given period. - The percentage of the total output accounted for by the largest firms in the market, without considering whether this output has been sold or not. - The percentage of total employment accounted for by the largest firms in the market. This does not take account of the fact that some firms may be more labour intensive than others in the same sector. A number of UK markets are highly concentrated. These include tobacco, soap powder and cement. The overall level of concentration in an economy is usually measured by the proportion of total output or sales accounted for by the largest 100 firms.

The costs and benefits of monopoly

A monopoly has certain costs and benefits to different groups of stakeholders. Here we will consider the effects on the firms themselves and on their consumers, employees and suppliers. From the point of view of the firm itself, the monopoly appears to have the advantage since it controls the market and makes large amounts of abnormal profit. In practice, however, barriers to entry can eventually be broken down and there is always the possibility that a rival may enter the industry. If a monopoly has state backing, it will be subject to strict regulations. For consumers, the lack of competition can be a disadvantage. A monopolist is able to restrict its output and charge a higher price, thus reducing consumer surplus. Unlike in a perfect market, a monopolist does not equate total revenue with total cost and thus makes an abnormal profit, which continues into the long run. This can be said to be at the consumer's expense. It is a transfer of resources from consumer to shareholder, i.e. owner of the firm. However, there is an opposite argument. In industries where firms can take considerable advantage of economies of scale, one large firm may be able to produce at a lower cost than a large number of small firms. Even if the large firm charges a price above average cost, that price may be lower than the price a perfect competitor would have to charge. Economists debate whether monopolists or perfect competitors are more likely to innovate (that is, put an invention into use). - Firms operating under conditions of perfect competition (if that happened in the real world) may innovate to keep up with competitors (but all would eventually do the same) and to take advantage of a rise in profits in the short run. In the long run, though, perfect knowledge and free entry will mean that new firms can enter the industry to take advantage of any supernormal profits, so any benefit of innovation may be short term. - Monopolists are likely to have money to spend on research and development as the costs may be lower than in an industry with many competitors. Employees may benefit from working for a large firm and may have good remuneration and job security. However, a firm which is a monopoly in a goods or services market is not a monopoly in the jobs market and employees are able to move to other firms if they are unhappy with their pay and conditions. The position of firms which act as suppliers to a monopoly will depend on the extent to which the monopoly is also the only buyer of their products. A firm which is the only buyer in the market is called a monopsony and this is discussed later in this topic.

Topic 3 - Perfect competition and monopoly

As you saw in Topic 2, market concentration measures the degree to which a market is dominated by a few large firms (a market which is highly concentrated) or contains competition between many firms (a market which is not concentrated). The greater the degree of concentration in a market, the lower the amount of competition, and vice versa. In Topics 3 and 4 we will examine four market structures, each of which has special characteristics which stem from the degree of competition in the market. The structures are: - perfect competition - monopoly - monopolistic competition - oligopoly. This topic looks at perfect competition and monopoly; Topic 4 focuses on monopolistic competition and oligopoly. We will examine their characteristics and study the behaviour of firms in these markets and their level of efficiency. In other words, we look at the level of concentration in each market and the extent to which there are barriers to entry for new firms and exit for existing ones. In studying firms' behaviour, we assume throughout that their aim is to maximise profits. You will remember from Unit 6 Topic 1 that there are other possible objectives which firms may have (e.g. revenue maximisation, sales maximisation) but economic theory recognises profit maximisation as the driving force for a firm. However, in the real world of business, profit maximisation is not the most dominant objective and large companies are usually more interested in market share.

Barriers to entry and exit

Barriers to entry are obstacles that make it difficult, or even impossible, for new firms to enter a market. Barriers to exit are factors that make it difficult or impossible for incumbent firms to leave the market. Barriers to entry: There are a number of factors that may inhibit an increase in competition in a market. They include: - High set-up costs -Starting up in some markets is very expensive and funding can be hard to get. For example, any firm wishing to enter the aerospace industry needs to have access to large amounts of capital to enable it to invest in large buildings and very expensive infrastructure and machinery. - Economies of scale - We have already studied economics of scale in Unit 6 Topic 4; go back to that topic now and refresh your knowledge if you feel you need to. Remember, economies of scale are factors which allow firms operating at a larger level of output to reduce their average costs. In sectors such as the chemical industry, economies of scale can be so significant that well-established firms have a considerable cost advantage over firms that are just starting up. New challengers cannot compete on costs and have to charge a higher and less competitive price in order to make a profit. This makes it hard to enter the market. Indeed, in the case of a natural monopoly (see Topic 3), economies of scale are so large that average costs are minimised if all the output is accounted for by one firm. - Advertising expenditure - Incumbent firms already have a name and a brand image. They are able to spend considerable sums on advertising, which a new entrant would find it hard to match. - Brand loyalty - Incumbent firms have built up a strong attachment between consumers and particular brands. Loyal customers have a lower price elasticity of demand and are likely to continue buying a known and trusted brand even if its price rises. This makes it difficult for new firms to build up a customer base. - Limit pricing-Incumbent firms can seek to discourage the entry of new competitors by charging prices below the point at which they make maximum profit. New firms may not be able to break even at such a low price, especially since they probably face relatively high costs before they can establish themselves. - Patents and copyrights - These are legal devices which allow people to have rights over their intellectual property. They protect inventors of new processes or writers of new material by preventing anyone else, for a stated period of years, from producing exactly the same product or from using the same productive process. This means that competitors cannot copy the products of incumbents and this makes it harder for them to enter a market. A good example of this is the pharmaceutical industry. Firms spend large amounts on researching and developing new medicines and they need to be able to protect their investment by stopping other firms from copying their product. Such action does, however, restrict competition. - Other legal barriers - A government may give a firm the sole right to produce a product. For instance, it may grant one radio station an operating licence to have the sole right to broadcast on a particular wavelength, or one railway company to serve a particular region. - Access to raw materials - One or only a few firms may own the source of the raw materials necessary for making a product. For instance, heavy metals such as antimony, used in the production of batteries, are found only in certain parts of the world. China is one such country and any firm which controls the supplies of this resource can restrict others from accessing it.

Topic 2 - Barriers and market concentration

Barriers to entry into a market are reasons why a new firm may find it hard to enter an established and profitable market in order to compete with those already there - known as the incumbent firms. Barriers to exit are reasons why an existing firm which is making a loss may find it hard to leave the market. In this topic, you will examine examples of barriers to entry and exit and consider how they influence the behaviour of firms. You will also examine the nature of market concentration ratios and learn how different degrees of market concentration can influence firms' behaviour.

Productive efficiency

Before you read what follows, be sure that you understand the reasons given in Unit 6 Topic 4 for why an average cost curve is U-shaped. Productive efficiency means that a firm is producing its output with a minimum amount of input, i.e. it is making the best use of its land, labour and capital and minimising its costs. It is producing at the lowest point on the average cost curve as shown in Figure 1.1 at point Q. If all firms could achieve productive efficiency, the economy would be operating on its production possibility frontier as there would be full and efficient use of resources.

Contestability and market structures

By definition, a perfectly competitive market is also a perfectly contestable market since there are no barriers to entry or exit. This is certainly the case in the short run when supernormal profits attract new entrants - and it could continue to be so in the long run as long as it is still possible to expand consumer demand. However, if the market is saturated (i.e. there is no more potential consumer demand to be captured and therefore no room for more firms in the industry), then contestability is low or zero. A pure monopoly does not appear to be at all contestable but, if we define it carefully, it can be contestable as long as there are no sunk costs. Take a case where a bus company is the only firm operating on a particular route. It seems to have a monopoly, but other bus companies may be attracted to start running buses on the same route if the incumbent is making supernormal profits or if it is operating inefficiently with high costs. If the new companies do not succeed in making a profit, they can exit the market and use their buses on other routes; their costs are not sunk. The implication is that firms in contestable markets, aware of the threat that firms will enter the industry if profits and costs are high, will seek to produce efficiently and will make only normal profits. The consumer may be able to benefit from the lower prices which are the result of economies of scale and avoidance of excessive levels of profit. The theory of contestable markets has influenced governments' privatisation programmes. For example, to increase competitive pressure on a privatised monopoly, a government could make entry into, and exit from, the industry easier by leasing specific capital to a firm running the industry on a franchise basis. An example of this would be putting the running of a college canteen out to tender. The UK government and financial regulators are keen to encourage more competition in the retail banking sector from 'challenger' banks. One of the barriers to entry for a new bank is the need to comply with rules on liquidity and capital requirements. These requirements impose a sunk cost on a new bank and make it harder for it to enter the market. The regulators have agreed to a partial relaxation of the requirements to make it easier for challenger banks to become authorised and set up in business. Some economists question the value of the theory of contestable markets. Their main criticism is that the theory does not explicitly take into account the reaction of incumbent firms to the threat of potential competition. They will not sit passively and wait for competition to appear but are likely to respond to the threat of potential competition by building up barriers to entry. In such a case, the market is potentially contestable and existing firms have taken pre-emptive action to reduce the threat of new firms entering the market.

Competition and efficiency

Competition may promote efficiency for two main reasons: - A firm in a competitive market is likely to lose sales and will go out of business if it does not produce at a low cost and does not make what consumers want. - While a firm in a competitive market will be punished for being inefficient, it will be rewarded if it is efficient. The reward will come in the form of profit. So competition can provide both a threat and an incentive for firms to be efficient. However, while competition may promote efficiency in terms of private costs and benefits, it may not ensure efficiency in terms of social costs and benefits. For example, firms may achieve productive efficiency by cutting labour costs, but this reduces workers' living standards. Similarly, a firm which does not spend money on reducing its carbon emissions may minimise its costs but impose the social cost of pollution on society. The Edexcel specification requires you to understand efficiency and inefficiency in different market structures. We will look at these concepts under the various market structures in the topics which follow, taking each structure as we come to it. We will be looking at the market structures of perfect competition, monopoly, monopolistic competition and oligopoly.

Price competition

Despite the kinked demand curve model, which shows that price competition is not a major feature of an oligopolistic market, we can find cases where firms in an oligopoly market do use price competition. It can take a number of forms, which have similarities between them. - Price wars. A price war happens when competitor firms continuously lower their prices, each trying to undercut its rivals. This sounds like a good situation for customers - and it may be so in the short run, as they are able to access good deals. But it may be more harmful in the long run. This is because a price war is often started by one of the companies in the oligopoly market, possibly the market leader, in order to increase its market share. It cuts its prices and increases its sales, so the competitors are forced to follow suit, especially if their products are not distinctively branded. This is a race to the bottom and, eventually, the price reaches a low point that only one firm can afford, probably the firm that began the process. By this time, the other firms may have left the market. - Predatory pricing. This is similar to a price war but it is a more extreme situation where a firm reduces its price below cost, i.e. to the point where it is actually making a loss. It does this in order to eliminate competition by forcing its rivals out of business. To be able to do this, the firm must have enough resources available to sustain greater losses than its rivals and to keep it solvent until it is able to raise the price again. An oligopolist may become a monopolist and, once its rivals have left, it can raise its price again and its customers have no choice. This is clearly against the public interest and EU competition law prohibits firms from selling goods at a loss with the intention of forcing other firms out of business. - Limit pricing. This is similar to predatory pricing but it is practised by an oligopolist or a monopolist as a strong barrier to entry to keep new firms out of the market. The firm sets its price just below the point at which it would maximise profits, thus reducing the amount of supernormal profit it is making. Put another way, the firm is increasing its output up to the point where a new firm cannot make any profit if it enters the market. This is a strategy that is often followed in industries where economies of scale are significant and therefore barriers to entry are high. New firms would have high costs and so would find it difficult to compete at a low price. Figure 4.3 shows that a firm, estimating that a price of PX will discourage attempts to enter the market, produces output QX since this can be sold at PX. The expected market price would be P, which is set at the point where MC = MR.

Dynamic efficiency

Dynamic efficiency is efficiency achieved over time, as opposed to static efficiency which is achieved at the present moment only. Firms are said to be dynamically efficient when they invest, innovate and train workers to keep pace with changes in consumer demand, to raise the quality of the products they produce, and to keep costs low. Firms willing to pay the opportunity cost in terms of time and money spent now on research and development may reap the benefit of higher sales and more efficient production in the future.

Game theory

Game theory is used to explain situations where 'players' have a range of strategic choices. It has various applications but in economics it is used to analyse how firms behave in a situation of oligopoly - in other words, when each firm is in a situation where its decisions are based partly on how they think their rivals will react to what they do. A famous example of game theory is the so-called 'Prisoner's Dilemma'. In this hypothetical case, two prisoners are arrested and held separately. Each prisoner could stay silent; they might be released without charge but, on the other hand, might receive a heavy sentence if the other prisoner implicates her or him in the crime. Alternatively the prisoner could confess in return for a light sentence. It is thought that the prisoners are likely to opt for the second best option - that is, to confess - because they are concerned about the risk of the other confessing. This outcome is compared to how the actions of oligopolists can lead to lower than possible profit. For instance, a firm may base its strategy on a cautious approach, assuming that its rivals will match any price cut it makes. It may, nevertheless, cut its price in a bid to maximise its minimum possible profit. This is known as maximin. Another strategy is to assume that its rivals will act in a way most favourable to itself, maximax. This time, the assumption will be that its rivals will not cut their prices. When both strategies lead to the same policy, it is known as a dominant strategy game. Game theory can also be used to emphasise the possible gains that oligopolists may receive from colluding. We can use a grid to show the different outcomes which may arise if two firms collude or compete. Table 4.4 shows the different outcomes if two airlines operating the same route collude by charging a high price, collude by charging a lower price or compete by charging different prices.

Hit-and-run competition

Hit-and-run competition is a feature of a contestable market. If there are no barriers to entry or exit, or if the costs of entry can be recovered, firms anticipating high profits in a market may enter for a short period to take advantage of those profits. When the profit levels start to fall, or are anticipated to fall, the firms will leave the market. They may actually stay in the market for a very short period before moving on to another market. For example, during the Christmas period a person may hire a stall in a market town to sell festive wrapping paper. This competition will keep down the price charged by large stationery shops such as WH Smith.

The effect of barriers on business behaviour

In Unit 6 Topic 5, you looked at supernormal profits. We noted that barriers to entry and exit can enable incumbent firms to protect any supernormal profits they are earning. These barriers can also reduce the pressure on incumbent firms to be efficient. This is because, if it is harder for new rivals to enter the market, incumbent firms which are not producing at the lowest possible average cost (i.e. are prone to X-inefficiency) and which are not adequately responding to changes in consumer demand are less likely to be driven out of business. There is also the possibility that the incumbent firms will spend time and money building up barriers rather than focusing on providing a good product for consumers. Nevertheless, barriers to entry and exit can improve efficiency in both incumbent firms and in potential entrants by promoting innovation. Incumbent firms may be encouraged to spend money on research and development into new processes and products and to introduce new methods of production, if they believe they may earn supernormal profits and be able to protect this ability into the future. Equally and conversely, firms outside the market may find that the only way they can overcome high barriers to entry is to develop better versions of products.

Performance in different market structures

In assessing the performance of firms in different market structures, we need to look at a number of areas: - Prices.The high level of competition existing under conditions of perfect competition will drive prices down to their lowest viable level given market conditions. However, if economies of scale exist, costs and prices may be lower under conditions of oligopoly and monopoly. This is particularly the case where there is a natural monopoly. This occurs when economies of scale are so significant and the minimum efficient scale so high that costs can only be minimised when all the output is produced by one firm. (Even this may not be large enough to reach the minimum efficient scale and this explains why some natural monopolies are supranational.) Any other market structure would be inefficient. - Profit levels.The absence of barriers to entry and exit means that firms producing under conditions of perfect competition and monopolistic competition can earn only normal profits in the long run. Firms producing under conditions of oligopoly and monopoly can earn supernormal profits in the long run, protected by imperfect knowledge and the existence of barriers to entry. Barriers to exit, such as sunk costs or long-term contracts, may also mean that firms in these last two market structures may experience a loss in the long run. - Productive efficiency.Under conditions of perfect competition, productive efficiency is achieved in the long run but it is not achieved under other market structures. . Allocative efficiency.While firms producing under conditions of perfect competition always achieve allocative efficiency, firms operating under other market structures fail to achieve allocative efficiency. - Dynamic efficiency.There is some uncertainty as to whether innovation is greater where there is a high or a low level of competition. As we will see later in this topic, a relevant factor here may be not the actual level of competition but the potential level of competition - dynamic efficiency. Firms may seek to reduce costs, lower prices and improve the quality of their products if they fear that new firms can enter their industry. - Consumer surplus.Consumer surplus is likely to be greater under conditions of perfect competition than under conditions of monopoly unless costs are significantly lower under monopoly. - Choice.Perfect competition offers the greatest degree of choice of producers and monopoly the least. However, while products are homogeneous under perfect competition, monopolistic competition and oligopoly offer consumers choice in terms of variations in products, which consumers often value. - Information.There is assumed to be perfect knowledge under conditions of perfect competition. However, knowledge about pricing, range of products and firms' strategies is imperfect in other market structures. There is the risk that persuasive advertising, used on a large scale in oligopoly, may result in consumers buying what producers want to sell (a situation of producer sovereignty) rather than producers supplying what consumers want to buy (a situation of consumer sovereignty). Remember that the market structures studied in economic theory are not precise or discrete situations in the real world; it is often the case that firms do not fall neatly into a particular structure. The extremes of perfect competition and pure monopoly are hard to find and most firms operate under a certain amount of competition. This means that they fall somewhere along the line between the limited competition of oligopoly and the greater competition found in monopolistic competition.

Analysis of price discrimination

In this analysis we split the overall market into the different subsidiary markets and assume two markets. We will use the example of a firm which has a monopoly in the domestic (UK) market but faces competition in the foreign export market. The monopolist will produce where the marginal revenue in each of the markets is equal to the marginal cost of producing the total output. It is important to remember this as it shows that the marginal cost is the factor which links the two markets. In Figure 3.5, Diagram A shows the home market in which the firm has a monopoly position. In this case, demand is not very price elastic because there are no competitor firms for consumers to buy from. The price charged will be relatively high. Diagram B shows the foreign market where demand is more price elastic as the firm faces foreign competitors. Price is lower in this market.

Summary of Perfect competition and monopoly

In this topic you have examined the characteristics of two different market structures and have considered how the degree of market concentration affects the ability of firms to influence price and the level of profits they earn. You have seen how graphs can be used to illustrate the price and output positions of firms in different market structures. The key points are as follows: - In the short run a perfectly competitive firm may earn supernormal profit or incur a loss. - In the long run, free entry to and exit from the market, and perfect knowledge, mean that normal profits are earned under conditions of perfect competition. - Perfect competition will provide consumers with a choice of sellers and an allocatively and productively efficient output. - Monopoly implies barriers to entry and the absence of competition; there are likely to be monopoly profits and no productive and allocative efficiency. - In perfect competition, firms are price-takers; a monopoly is a price-maker. - In perfect competition products are homogeneous but in monopoly the product is unique.

Summary of Monopolistic competition and oligopoly

In this topic you have examined the characteristics of two different market structures in some depth and have considered how the degree of market concentration influences the ability of firms to influence price and the level of profits they earn. You have seen how graphs can be used to illustrate the price and output positions of firms in different market structures. The key points are as follows: - Monopolistic competition provides a choice of differentiated products and sellers. However, it does not achieve productive and allocative efficiency. - Oligopoly is characterised by barriers to entry, supernormal profits and non-price competition. - Collusion may be a feature of oligopoly. - A cartel seeks to maximise the profits of a group of producers by acting as a monopoly seller. - Game theory can be used to examine how firms behave in an oligopolistic market where there is a high degree of interdependency. Now let's bring in perfect competition and monopoly (Topic 3): - The number of firms in the industry in different market structures varies from infinite in perfect competition to one in pure monopoly. - There is free entry into and exit from industries operating under conditions of perfect competition and monopolistic competition. - There are barriers to entry and exit in oligopoly and monopoly. - In perfect competition, firms are price-takers; in monopolistic competition, oligopoly and monopoly firms are price-makers. - In perfect competition, products are homogeneous; in monopolistic competition and oligopoly, they are differentiated; and in monopoly, the product is unique.

Topic 4 - Monopolistic competition and oligopoly

In this topic you will look at the two real-world situations of monopolistic competition and oligopoly, which sit in between the two extremes of perfect competition and monopoly studied in Topic 3.

List four ways in which high-street banks seek to attract customers.

Internal layout of branches, opening hours, design of cheque books, location of branches, free gifts for opening accounts, persuasive advertising, range of direct banking and other services available, and interest rates.

Perfect competition

It is important to note that what we are about to describe is a theoretical situation and not one which you will find in the real world. Perfect competition stands at the extreme end of the concentration/competition continuum and is a situation of total competition and no concentration whatsoever. It is an ideal world which serves the consumer best. Despite its unreality, it is worth studying it as it shows us what a perfect market would be like if one could exist. It causes us to define a perfect market very closely indeed and this becomes useful when we study real-world markets because we can recognise, by comparison, the market imperfections which exist within them. We can then devise policy measures in order to reduce these imperfections. Here are the main characteristics (or assumptions) of a perfect market: - There is an infinitely large number of firms competing. - Each firm is so small that it cannot influence the market by any of its actions. - The product made by all these firms is identical - we say that it is a homogeneous product. 'Homogeneous' means 'of the same kind'. - There is one market price which every firm charges, i.e. there is no price competition. Each firm is a price-taker. - The market demand curve for the product is perfectly elastic. - No firm spends any money on advertising or marketing - there is no point, since products and prices are all the same. - All firms and all consumers have perfect knowledge of market conditions. - If any firm did try to undercut the market price, there are no time or travel costs to any consumer of buying from this firm. - There are no barriers to entry to the market to new firms who want to come in and compete; neither are there any barriers to exit to firms which want to leave the market. If we put all these strict conditions together, we can see that perfect competition actually means hardly any competition. No firm has any power whatsoever. Its products are exactly the same as every other firm's products and are sold for the same price. If a firm tries to step out of line, it will lose because consumers' demand is perfectly elastic. If it raises its price to expand its profit margin, all consumers stop buying from it as they know where to go to find an identical product for a lower price and it costs them nothing to do this. So no firm will do this as its sales will drop to zero. Conversely, no firm has any incentive to drop its price to sell more, as it is so small that it is already selling all its production at the market price. You can see that such a market does not exist, although a few markets do exhibit some of these conditions and possibly come close to perfect competition, for example the stock market.

The equilibrium output of a monopolist

Note that the cost curves are similar to those used in the model for perfect competition, but the revenue curves are different. The monopolist faces a downward-sloping (negatively-sloping) demand curve of AR. The very limiting conditions of a perfect market do not apply here and, in order to sell more units, a monopoly has to reduce the price. However, because of the lack of competition, the demand curve will be relatively price inelastic and will have a steep slope. The MR curve follows the AR curve; since AR is falling throughout, MR is also falling and is also below AR at each level of output. This is because, in order to bring the average down, each additional unit sold must be lower in price than the average. See Figure 3.4 below. Just as in the case of perfect competition, we assume that a monopolist operating in a private sector market seeks to maximise profits and this will happen at the output where MC = MR, i.e. at output Q. We draw a vertical line from this output up to meet the AC and AR curves. At output Q, total cost is AC × output = the area of rectangle 0QAC. Total revenue is AR × output = the area of rectangle 0QBP. TR is greater than TC and the difference between the two rectangles is CABP. This represents supernormal or abnormal profit. (Remember that normal profit is included in cost.) In a perfect market, this supernormal profit will attract new firms. But in a monopoly, by definition, there is no competition and so the monopolist is able to earn this high level of profit into the long run. Figure 3.4 thus illustrates both short-run and long-run equilibrium. Note that the firm is in equilibrium at a point where AR is greater than AC. If the monopolist were to produce that output where AR = AC, thus making normal profits, output would be higher and the price would be lower. We can therefore conclude that a monopoly keeps price high by restricting output. This firm is not achieving allocative efficiency. We can also see from Figure 3.4 that the monopolist is not producing at the lowest point on the average cost curve and is thus not achieving productive efficiency.

Characteristics of an oligopolistic market

Oligopoly is a market structure which is dominated by a few large firms. Even if the market contains a number of smaller firms, the largest few firms account for most of the output, sales and employment in the market. An oligopolistic market has the following features: - There are high barriers to entry into and exit from this market. These barriers are often based on high start-up costs and economies of scale, which give the advantage to incumbent firms, i.e. those firms already operating in the market. Because the firms are few and large, they can also take active and effective steps to make it hard for new firms to challenge them. This means that supernormal profits being earned by the few are not absorbed by new competitors and so this level of profit can be earned by each large firm in the long run. - The market is highly concentrated, i.e. a few firms account for a high percentage of the market share, whether measured by sales or by revenue. This not only limits consumer choice but also has other implications. In 2014, the four largest banks in the UK - LLoyds Banking Group, HSBC, Royal Bank of Scotland and Barclays - accounted for approximately 70% of the market for personal current accounts and 80% of the market for business current accounts and loans to small businesses. (Competition and Markets Authority, 2015) - Firms in an oligopolistic market are very interdependent. Because all the firms are big, they monitor each other's actions, policies and performance very carefully and each firm is significantly influenced by the behaviour of the others. When deciding its market strategy, each firm takes into account what its competitors are doing and how it believes its competitors will respond to its actions. If, for example, one firm decides to cut its prices in order to increase its market share, its rivals will soon find out. The rivals will now decide whether or not to follow suit and match the price cut, so as to remain competitive. If the first firm believes they will copy the price cut, it will be dissuaded from taking the action in the first place as it will see that the advantage gained will not last very long. Indeed, the market price will be lower across the board and all the firms may earn lower profits, other things being equal. This interdependence can sometimes lead to collusion, as we shall see below. - Price and non-price competition. The result of the interdependence described above is that firms operating in an oligopoly tend not to practise price competition (see later for more detail). However, they do focus strongly on non-price competition, i.e. on product design, heavy and aggressive advertising and various marketing techniques. For example, a national newspaper may decide to give away DVDs in its weekend editions rather than cutting the price of the newspaper. Again, other newspapers may follow suit. So each firm must try to achieve a strong brand image in order to gain loyal customers. - Firm in an oligopoly situation are not productively efficient because they are not operating at the lowest point of the average cost curve. Like a monopolist, they are to an extent able to restrict their output to keep their price higher and this is especially so where they collude. Equally, they are not allocatively efficient because the price they charge exceeds marginal cost.

Overt collusion

Overt (or formal) collusion means that competitors actually make an agreement between themselves to limit competition. This is usually in the form of a cartel, which is a single selling agency which makes anti-competitive agreements on behalf of its members. The Competition and Markets Authority (CMA) defines a cartel as a situation where 'two or more businesses agree not to compete with each other in certain ways'. The member firms produce separately but the cartel sets the price with the aim of maximising the profits of the members as a group. To ensure the set price it also usually sets output and shares out the total output by means of allocating a quota for each firm's output. In effect, the industry acts as a monopoly, especially if all firms in the industry are members. For a cartel to be successful, it is important that as many firms in the industry as possible are members and that they can stop new producers from entering the market. If this is not possible there is a high risk that the cartel will be undercut and that its members will lose market share. For the cartel to continue it is also important that the members have similar costs, otherwise the price set will benefit some more than others. In addition, the firms must have similar objectives and must not cheat. In practice, cartels tend to be unstable because members may disagree on policy. Cartels are illegal in most countries, including the UK where they are prohibited by the Competition Act 1998. In practice, cartel arrangements often break down, mainly because of the different interests and cost positions of members. The Organization of Petroleum Exporting Countries (OPEC) is an international cartel of countries which, since 1960 when it was formed, has attempted to keep the price of oil high by restricting production. Its members do not always agree, however, as politics enters the scene. For example, when oil prices fell in 2014, OPEC wanted to reduce global production but a number of members, including Saudi Arabia, the biggest member, would not agree to do this. OPEC has a lot of power in the oil market; however, this power is limited by the fact that not all oil-producing countries are members. The Competition Act 1998 in the UK and Articles 81 and 82 of the EC Treaty prohibit 'anti-competitive agreements between businesses and the abuse of a dominant position by a business ... Cartels are a particularly damaging form of anti-competitive activity. Their purpose is to increase prices by removing or reducing competition and as a result they directly affect the purchasers of the goods or services, whether they are public or private businesses or individuals. Cartels also have a damaging effect on the wider economy as they remove the incentive for businesses to operate efficiently and to innovate'. (Office of Fair Trading, 2005, Introduction to Cartels and the Competition Act 1998) There are various ways in which collusion can take place: - price fixing, where firms agree not to compete on price - bid rigging, where firms make agreements with rivals when tendering for new contracts - sharing markets and customers - sharing information with a view to reducing competition.

Pareto efficiency

Pareto efficiency is named after Vilfredo Pareto (1848-1923), an Italian engineer who developed the concept in his work on economic efficiency in engineering. It is an important concept in economics so, although it is not specified on your syllabus, it is worth treating it briefly. Pareto efficiency happens when it is not possible in an economy to make someone better off without making someone else worse off. For example, in order to build a new housing development, a building firm has to find land. Suppose the firm finds a brownfield site where a factory used to be situated but which is now derelict and not producing anything. The building firm can create value and make a number of people better off - the firm itself, its employees and the people who will buy the houses. But no one will be worse off because the site was not in use. So Pareto efficiency does not exist while such old sites are available. However, if all old brownfield sites have been used and the building firm has to buy agricultural land for its development, the building firm and house buyers are better off but farmers and their consumers are worse off. The economy could have been Pareto efficient before the builders moved in but it might not have been if society puts a greater value on more houses than on more food. Pareto efficiency does not measure equality between people or overall wellbeing and so it does not necessarily result in a socially desirable distribution of resources. However, for an economy to achieve Pareto efficiency, it must be both productively and allocatively efficient. Figure 1.3, which you should recognise as a production possibility curve, shows that production point A is not Pareto efficient. This is because it would be possible to increase output, for example to point B, which would enable more products to be enjoyed without anyone having to forgo any products. It would, however, not be possible to determine whether a particular point on a production possibility curve is Pareto efficient without more information on consumer preference. For instance, a society that places a high value on education is more likely to be Pareto efficient at point B than at point C.

Effects of price discrimination

Price discrimination has an advantage for producers who are able to practise it because it allows them to increase the revenue they receive from their sales. A monopolist can raise its price for those consumer groups whose demand is more inelastic and whose consumer surplus is higher, while at the same time keeping the price lower for those whose demand is more elastic and who would refuse to buy the product at a higher price. So the firm maximises its revenue from consumers in the group who are willing to pay more and also keeps its customers in the group who are not willing to do so. Most firms would like to do this, but the existence of competition in the market would make it impossible, as other firms would enter the market and cut the price for those customers who are paying more. The main disadvantage for a firm which practises price discrimination is that it can gain a bad reputation with consumers believing that they are being exploited. But if the firm is a monopolist, it might not care much about its reputation. This is an interesting point to debate! Price discrimination disadvantages consumers to the extent that it reduces their consumer surplus. Consumers are treated differently, with some gaining and some losing from the way in which the market is divided. Consumers can also lose choice in the market as price discrimination can be used by a large firm to gain monopoly power by driving out competitors. For example, a bus company might charge lower fares in a region in order to eliminate the local competition. However, consumers can also benefit from price discrimination. Those who pay the lower prices, for example children paying lower fares on buses or lower prices at places of entertainment, may be able to afford products they would not otherwise have been able to buy. Price discrimination can also bring benefits to those consumers who pay the higher prices by allowing a firm to grow its revenue and become bigger in the market. This means that the firm can operate on a larger scale, benefit from economies of scale and be able to charge lower prices to both groups of consumers than would otherwise have been the case. Lastly, price discrimination may secure the supplies of a product by enhancing the firm's revenue and, other things being equal, its profits. Consumers might be able to buy a product that would not be profitable if sold at one price to the whole market.

Price discrimination

Price discrimination is a practice which can be carried out by a firm which possesses a degree of monopoly power. It involves charging different prices to different groups of consumers for identical products that have the same costs of production. (This is known as 'third degree' price discrimination; there are also first and second degree levels of price discrimination, but the specification does not require you to study these.) Consumer groups can be distinguished in terms of some particular qualification such as age or current status. For example, cinemas charge a lower price to children than to adults; some banks charge a lower rate of interest on credit cards to new customers compared to existing ones. Or customers can be distinguished in terms of season or time of day; an example of this is given below. Price discrimination is a method by which a monopolist can increase its profits margin by charging the normal price to those customers who have little or no consumer surplus and a higher price to those customers who have a higher consumer surplus and who are willing to pay more than the normal equilibrium price, or who cannot avoid paying more. In other words, because there is no competition, a monopolist can convert some consumer surplus into producer surplus and earn a higher overall profit. Price discrimination can occur if three conditions are met: - The firm must be a price-maker; a monopoly fulfils this condition as it is the only firm in the market. - It must be possible to keep the different markets separate so that the product cannot be bought in the cheaper market and then resold in the higher-priced market. An example of this is a railway company which charges higher fares during peak times of the day. It is impossible for passengers to travel during the rush hour and to pay an off-peak fare. In effect, customers must qualify to belong to the market where the price is cheaper, either by age, time of day or some other suitable feature. - The price elasticity of demand must be different in the two markets. The monopolist will charge a higher price in the market where the demand is more inelastic because demand will fall by a lower percentage than the price will rise, and so the monopolist will gain a higher revenue in that market. The lower price must be charged in the market segment where the demand is more elastic and where people are more willing to reduce their demand or stop buying altogether if the price is too high. For example, someone who has to arrive at work by 9.00 am has no choice but to catch an early train, but a retired shopper can potentially travel at any time of day.

Which is NOT an example of price competition? a) limit pricing b) predatory pricing c) price leadership d) price war

Price leadership (c) is not price competition, but a situation where one dominant firm takes the lead over the setting of a market price.

Sunk costs

Sunk costs are costs which a firm has already incurred, either in the course of setting up in business or in its operations, and which cannot be recovered. Sunk costs are in the past; they do not affect and are not affected by events which may happen in the future. When a firm enters a market to compete with the incumbents, it has to pay certain start-up costs, for example the purchase of buildings and equipment, staff training and licences. If the firm goes out of business, it will be hard to recover some of these costs. The extent to which it may recover a cost depends on whether it can sell off its assets, and this in turn depends on whether there is a market for the assets. For example, a firm which has purchased a fleet of delivery vans can probably find a buyer, although depreciation means that it will not recover the original price it paid for them, so the cost is partly sunk. If an asset is very specific, it will be harder to sell. For example, a firm producing whisky would find it hard to sell off its distillery equipment as only another whisky firm would be interested in buying it, so the cost is almost certainly sunk. Costs such as staff training and the purchase of licences or copyrights are sunk costs since there is no refund if the firm goes out of business. Examples of businesses with no sunk costs can be found in people who perform professional services and work from home on an IT system which they already have, for example accountants, translators and book editors. The cost of setting up in business is very low and can probably be recovered.

Market concentration and business behaviour

The behaviour and performance of firms is influenced by the level of competition in the market in which they operate. The more that market power is concentrated in the hands of a few firms, the greater the ability of these firms to set prices and the greater their potential to earn supernormal profit in the long run. But we have to be careful in interpreting market concentration ratios. First, they measure actual and not potential competition. A market may be heavily concentrated, but if there are no or only low barriers to entry into and exit from the market, potential competition may put pressure on the firms to keep costs, prices and profits low. This is known as a contestable market (see Topic 5). Another point to note is that, while market concentration ratios are usually nationally based, firms operate in regional and local markets, and market concentration ratios can be defined in geographical terms. For example, Tesco used to account for around 90 per cent of grocery sales in Bicester, Oxfordshire, leading to the town being called a Tesco Town. This share fell in 2015 after the opening of a new Sainsbury's store. Market concentration ratios can also be stated in product terms. For instance, the specific personal current account market is more highly concentrated than the more general financial services market.

How may product differentiation result in a barrier to entry? a) It can develop consumer loyalty b) It can increase average revenue c) It can lower start-up costs d) It can raise expectations of profitability e) It can reduce average costs

The correct answer is (a). Making a firm's product distinctive can create brand loyalty and make it difficult for new firms to attract customers to their lesser-known products. It is uncertain whether (b), (c) and (e) would result from product differentiation and, if that were the case, new firms might be attracted into the market. (d) would encourage new firms to seek to enter the market.

What is the main difference between a firm operating in perfect competition and a monopoly firm? a) The perfect competitor engages in advertising, whereas the monopolist does not. b) The monopolist seeks to maximise profits, while the perfect competitor seeks to maximise sales revenue. c) The perfectly competitive firm will always produce at the lowest average cost, whereas the monopolist will produce where average cost is still falling. d) The monopolist will achieve allocative efficiency in both the short and the long run, whereas the perfectly competitive firm will only achieve allocative efficiency in the long run. e) The monopolist can only increase sales by lowering price, whereas the perfect competitor can sell any quantity at the going market price.

The correct answer is (e). A perfect competitor faces perfect elastic demand and cannot influence price, whereas a monopolist is a price-maker, facing a downward-sloping demand curve and, given no changes in demand conditions, can only sell more by lowering price. In perfect competition there is no advertising; it is assumed that perfectly competitive firms aim to maximise profits; they do not produce at lowest average cost when they are earning supernormal profits or losses, but achieve allocative efficiency at all times.

In which business are sunk costs the most significant? a) A dance studio b) A greeting cards shop c) An estate agency d) An insurance company e) A zoo

The correct answer is (e). If a zoo shuts down, it may find it hard to sell its equipment and animals. By contrast, (a), (b), (c) and d) have less specialised equipment and their premises can be easily converted to alternative uses.

What is the aim of predatory pricing? a) to maximise profits b) to keep prices as low as possible c) to form the basis of a price cartel d) to discourage the entry of new firms e) to drive competitors out of the market

The correct answer is (e). Predatory pricing is an aggressive pricing strategy. By lowering its price the firm is seeking to drive rivals out of the market. Answer (d) is the aim of limit pricing.

Which of the following industries is a natural monopoly? a) Banking b) Car manufacturing c) Construction d) Publishing e) Water distribution

The correct answer is (e). Water distribution is a network; but note that water distribution in the UK is now carried out by private companies, each of which serves one of 10 regions. (a), (b), (c) and (d) are sectors where there is competition.

Topic 5 - The threat of competition

The first half of this topic will give you an opportunity to consolidate and revise what you have learned In Topics 3 and 4 about the four main market structures. In this topic you will make some comparisons between them, explore the behaviour and performance of firms in the different market structures and consider different pricing strategies. In the second half of the topic, you will examine the concept of contestable markets.

Calculate the four-firm market concentration ratios for grocery sales in 2005 and 2015 and comment on the degree of market concentration.

The four-firm market concentration ratio rose from 66.1 per cent (the total of the figures in the left-hand column) in 1998 to 76.2 per cent in 2008 (the total of the figures in the right-hand column). This means that the market has become more concentrated, due largely to the rise in market share enjoyed by Tesco. Asda's market share also rose, moving it from fourth to second position. In contrast, the market shares of Sainsbury's and Morrisons fell.

The kinked demand curve

The kinked demand curve relates only to a firm operating in an oligopolistic market and it has a special shape. It illustrates why oligopolistic firms are often reluctant to raise or lower their prices (see Figure 4.2). To understand it, it is necessary to bear in mind that a firm in such a market makes a price decision only after considering what other firms have already done or are going to do. At prices above P in Figure 4.2, demand is relatively elastic. This is because if one firm raises its price, the other firms are unlikely to follow because they want to remain competitive. So the firm which has raised its price loses revenue as customers switch to competitor firms. Any increase in price by the firm will cause its demand to fall more than proportionately. For this reason, the original firm will not raise its price. At prices below P, demand is relatively inelastic. This is because if one firm drops its price, the other firms will follow suit so as to remain competitive. Thus a fall in price will not bring in a lot of additional customers because they are happy going to the other firms, which have matched the price reduction. So the original firm will lose revenue because the fall in price is not bringing in a proportionately higher demand. For this reason, the original firm will not lower its price. The conclusion is therefore that no firm has any incentive to raise or to lower its price and that the price in the industry as a whole will settle at the point of the kink in the demand curve. So prices are likely to be relatively stable under conditions of oligopoly. Since firms do not engage in price competition, they must find alternative strategies to increase their sales. The two other main strategies are to engage in: - collusion, or - non-price competition. However, note that there are critics of the kinked demand curve. One major criticism is that the curve does not explain how prices are initially determined. Also it is hard to find empirical evidence to support the theory behind the curve. This is especially so given that any price stability noticed in a market can be due to one of a number of other factors including, for example, firms basing their prices on a profit margin added to their long-run average costs. -Study hint: Always bear in mind that economic models are just that - models - and are often poorly illustrated by behaviour in the real world.

Reasons for collusive and non-collusive behaviour

The main reason why firms may collude is that they can fix prices at a level which is higher than the level which would have settled in the free market if each firm had acted independently. This gives all firms a higher profit margin. In effect, their collusion turns them, as a group, into a monopoly and allows them to exercise monopoly power. They can restrict their output and keep prices high, thus earning supernormal profits. At the same time, they are neither productively nor allocatively efficient, in a similar way to a monopoly. But firms which collude run the risk of being in breach of the country's competition legislation and of being forced by the competition authority to change their behaviour. They also risk being charged a heavy fine, having their directors disqualified or even having their directors go to prison. Non-collusive behaviour is practised by firms which do not want to break the law or which are not dominant in their market. Collusion is probably less likely the greater the number of individual firms in the market, although by definition an oligopoly cannot contain more than a few. Non-collusive behaviour involves each firm using publicly available information to read the market correctly and guessing what its competitors are going to do.

Contestable markets

The theory of contestable markets was developed by William J Baumol in 1982. He said the following: "There are markets served by a small number of firms that are nevertheless characterised by competitive equilibria (and therefore desirable welfare outcomes) because of the existence of potential short-term entrants." It is important to grasp that this theory is not a fifth market structure, but a different approach to the four structures you have studied. It states that what matters in determining firms' behaviour is not the level of actual competition now but the level of potential competition in the future. In other words, incumbent firms react not only to their existing competitors but also to the threat of future competition. The degree to which a market is contestable depends on the barriers to entry and exit, which we studied in Topic 2. A market that has no barriers to entry or exit is perfectly contestable. A market would also be contestable in a case where any costs of entry can be recovered if firms exit the industry - in other words, where firms can enter or leave the industry quickly and without difficulty. If a firm knows that it can recover its costs if it has to leave the market, then it is willing to pay the costs of entering the market. If it knows that these costs would be irrecoverable, however, then the costs of entry become more of a barrier. It is this knowledge which is important and which would act as a barrier. As you saw in Unit 6 Topic 4, costs which cannot be recovered are known as 'sunk costs'.

Structural and strategic barriers to entry

There are different types of barriers to entry: - Structural barriers arise naturally in the industry and include high set-up costs and economies of scale. One aspect of structural barriers is the minimum size dictated by the nature of the sector and also the size at which an individual firm is able to start production. For example, in a sector like media communications, which requires heavy initial capital expenditure, only large firms can enter to compete. So a firm which can start producing on a relatively large scale because it has large retained profits is in a better position; it is more likely to be able to break into the market than a firm starting with a low production level. - Strategic barriers are built up deliberately by incumbent firms to prevent the entry of new competitors; they include low pricing, brand names and high advertising expenditure. These factors are barriers to unknown firms, but a firm that already has a well-known name can more easily diversify into another market by transferring its name. For instance, Virgin is well known for music and air travel, and now it is hoping that its brand will help it to develop its bank, Virgin Money UK. A patent is a licence which gives sole right to an inventor to exclude other people from making use of his or her invention for a specified term of years. Patents protect inventions from competition and also act as a strategic barrier to possible rivals. Patents last for a long period of time, usually around 20 years. To overcome a patent, a competitor firm could seek to develop a better version of the product, but this requires considerable spending on research and development. But there are cases where an inventor can develop a new version of the same product type. The inventor James Dyson has patented a number of successful products, the best known of which is the Dyson floor cleaner. His latest product is a new type of hair dryer, and the patent will prevent others marketing the same product for a long period.

Long-run equilibrium in a perfect market

This process continues in the short run, with supernormal profits being competed away by new firms and with losses driving old firms out of the market, until in the long run there is just the right number of firms operating in the market, each making just normal profit. -Advantages and disadvantages of perfect competition: In Figure 3.3, the firm is maximising profit at price P1 and output Q1. At this point, AR = AC, TR = TC and the profit is just normal. There is no incentive for new firms to enter or for incumbent firms to leave the market and so the industry is in equilibrium. Since each firm is earning just enough profit to keep it in the industry, it is not making an excess profit at the expense of the consumer. This output also means that the firm is producing on the lowest point of the average cost curve and so it is achieving productive efficiency as it is minimising its costs. This may not happen in the short run but it certainly does happen in long run. The firm is also producing the allocatively efficient output (AR = MC) and is therefore allocating sufficient resources to the production of the product. However, perfect competition also has potential disadvantages. Consumers have a wide choice of producers but not of products as the products are homogeneous. There is no scope for new designs or brands and everyone has to buy exactly the same product as everyone else. Prices are kept low by the high degree of competition. However, they may not be as low as they could be if the firms were bigger and had the finance necessary to engage in research and development, which could improve the quality of the product and reduce its price.

Summary of Barriers and market concentration

This topic has concentrated on the barriers to entry and exit that may exist in a market and their implications for efficiency, and on the concept of market concentration and its effects. The key points are: - There are obstacles to new firms entering and existing firms leaving some markets. Some barriers to entry arise naturally in a market, while others are built up by the incumbent firms to keep rivals out. - Barriers to entry include high set-up costs, economies of scale, advertising expenditure, brand loyalty, access to raw materials, limit pricing, patents and other legal barriers. - The two key barriers to exit are long-term contracts and sunk costs. - Barriers to entry and exit can make incumbent firms complacent divert their attention from responding to changes in consumer demand. On the other hand, barriers may promote efficiency by encouraging new firms to innovate and develop new products. - A market concentration ratio measures the extent to which sales, output or employment is accounted for by the largest firms. - Firms in a highly concentrated market may have considerable market power, but it is also necessary to consider potential competition. - A high degree of market concentration may promote inefficiency, but may also lead to higher efficiency. - Market concentration ratios are influenced by the geographical scope of the market and how markets are defined.

Allocative efficiency

To understand allocative efficiency, you have to remember the concept of relative scarcity and how human wants are infinite but the resources available to satisfy those wants are finite. If an economy has allocative efficiency, it has achieved optimal (the best) distribution of scarce resources between consumers' competing wants. There is the best match between the resources which are made available and the preferences of people for those resources. In other words, allocative efficiency occurs when firms produce the right products in the right quantities. To understand this, we need to look at the production of one good or service. How many units of this good should be produced? We cannot use numbers as we would have to specify a good and find data on it. Instead we can use the concept of the margin to make our decision. Remember that a marginal unit is an additional unit; in this case, it is an additional unit of the good under discussion. Are enough units of this good being produced to satisfy consumers' wants? Would another unit add to total satisfaction? If producing another (the marginal) unit adds more benefit to consumers than the cost of producing it, clearly it is worth going ahead with it. But if the cost of producing it is greater than the benefit derived from it, then it should not be produced. In between these two extremes there is a point where the benefit derived from the marginal unit is just equal to the cost of producing it, i.e. where: marginal benefit = marginal cost If people believe they benefit from consuming the product, they are willing to pay a price to buy it. So we can therefore conclude that a good should be produced up to the point where: price = marginal cost If all goods and services are produced in quantities such that the above condition applies, the economy is allocating its resources in an efficient way. This output, sometimes also known as the socially optimum output, equates the value that consumers place on the product and the cost of producing the last unit. In Figure 1.2 the allocative efficient output is QX. At this output, the resources devoted to the product will be sufficient to meet the demand of consumers at a price that matches the satisfaction they receive from the product. An output of Q1 would be allocatively inefficient. Not enough resources are being devoted to the product because the value that consumers place on the product exceeds the cost of producing the last unit. Raising output to QX would raise consumer welfare. But an output of Q2 would also be allocatively inefficient because too many resources are being devoted to producing it. At Q2 the cost of making the last unit exceeds the value that consumers place on it. Consumer welfare would be increased by reducing the output to QX and transferring some of the resources to producing other products.

Profit-maximising equilibrium under perfect competition

We are going to look at equilibrium in a perfect market and this will mean distinguishing between the short run and the long run. Remember that the short run is that period of time during which at least one factor of production is fixed; the long run is that period during which all factors are variable. In terms of competition analysis, the short run is also the period during which new firms do not have time to enter a profitable market and existing firms do not have time to leave a loss-making market. As you are already aware from Unit 6 Topic 1, we study profit maximisation by drawing graphs. No matter what market structure we are studying, we need to bring together four identities: - marginal revenue (MR) - marginal cost (MC) - average revenue (AR) - average cost (AC). The individual firm is in equilibrium at that point of output and price where it maximises profit, i.e. where marginal revenue equals marginal cost. MR = MC This can happen in both the short run and the long run. The industry of all the firms is in equilibrium at the point of output and price where each firm is earning just normal profit; this is where average revenue = average cost. AR = AC In a perfect market, this happens only in the long run.

Features of market structures

We can identify a number of key features which help to categorise industries into different market structures, all of which you have considered in earlier topics: - Market concentration ratios. In perfect competition, with many firms supplying the market, there is a very low degree of market concentration. In contrast, a pure monopoly has a one-firm market concentration ratio of 100 per cent. In between these two extremes come oligopoly, with a relatively high degree of market concentration, and monopolistic competition, which has a low degree of market concentration. - Barriers to entry into and exit from the industry. The more difficult it is for firms to enter and leave an industry, the lower the degree of competition and the higher the degree of concentration there is likely to be. Barriers also enable supernormal profits to be earned in the long run. Barriers to entry and exit are significant in the case of oligopoly and, to an even greater extent, in monopoly. However, they are absent in perfect competition and low or non-existent in monopolistic competition, which means that only normal profits can be earned in the long run. - The ability to influence price. The infinite number of firms in perfect competition means that any action by an individual firm to change its output would be too small to affect price. The firms are quantity-adjusters but price-takers, and their average revenue equals marginal revenue. In other market structures the firms are price-makers and average revenue exceeds marginal revenue; both average and marginal revenue decline with output. - Whether there are variations in the product. In perfect competition, products are homogeneous, whereas in monopolistic competition they are slightly differentiated. In oligopoly there can be a high level of product differentiation, with heavy branding being a key feature of some oligopolistic markets. In the case of pure monopoly, the product is unique. In addition to the above, the way firms behave is also influenced by the market structure in which they operate. - It is usually assumed that firms will aim to maximise profits and so will produce where MC = MR. However, some firms producing under conditions of oligopoly and monopoly may pursue other objectives such as revenue maximisation or market share. - Firms producing under conditions of monopolistic competition and oligopoly engage in non-price competition. This is a key feature of oligopoly where firms allocate large budgets to product branding and advertising campaigns. - Under conditions of perfect competition and monopolistic competition, firms act independently, whereas in oligopoly, firms are interdependent. They take into account other firms' reactions to changes in the output they produce, the price they charge and, for instance, the advertising campaigns they run. - Collusion can be a feature of oligopoly but not of monopolistic competition or perfect competition. It does not occur in pure monopoly.

Monopolistic competition

We have now looked at the two extremes of an infinite amount of competition in a perfect market and no competition whatsoever in a monopoly. The real world falls somewhere between these two extremes,. and markets in practice are imperfect, i.e. they do not satisfy the assumptions which underpin a perfect market. Many real-world markets come under the heading of monopolistic competition, which combines features of both monopoly and of competition. The name 'monopolistic competition' may sound confusing as it appears to combine the two extreme types of competition which you studied in the last topic. You might be wondering how the words can come together to describe a third market structure. The accent is on competition, because the market you are about to study contains a lot of competition. But, because each firm produces a product which is different from the products of its rivals, it can be said to have a 'monopoly' in its own brand. Hence the market structure is known as 'monopolistic competition', i.e. firms compete but the conditions are not perfect and each firm can attract loyal customers. In monopolistic competition: - There are quite a large number of firms in the market, but these are of different sizes. - Each firm sells a differentiated product. This means that each individual firm's product, although it comes under a generic heading, is unique because it is slightly different from the products of other firms. This is because the firm deliberately differentiates its own product by means of design, quality, branding and advertising in an attempt to sell a more competitive product than those of its competitors. Product differentiation is a fundamental feature of monopolistic competition. - There is price competition. Each firm chooses the price at which it sells its own brand of product. The firm tries to set the price high enough to cover costs and make a profit but low enough to be competitive. - There is relatively free entry into the market and exit out of the market. There may be some barriers but these can often be surmounted. - Firms and their consumers do not have access to full information about all the products and prices on the market. - There is a time and transport cost to consumers of finding and accessing the cheapest products. - Individual firms can make abnormal profits in the short run, but these are mostly absorbed by competition in the long run. However, some firms may be able to continue to earn a small amount of abnormal profit. - Firms are likely to operate at less than the productively and allocatively efficient output levels. An example of a market where there is monopolistic competition is the 'eating out' market in most towns and cities, where there are many public houses and restaurants which operate under the conditions set out above. Other examples are firms which make mattresses, taxi firms, hairdressers, clothes manufacturers and many more. Go online and see how many of each of these you can find! The industries in which monopolistic competition is common tend to be those in which the initial capital requirements are relatively small, and in which any technology is relatively simple and relevant technical knowledge is widely available. The firms are likely to be profit maximisers and produce where MC = MR. As they are selling a unique product, they will be price-makers and will have downward-sloping average revenue and marginal revenue curves. This means that average revenue will exceed marginal revenue at each level of output, as you have learned previously. Demand tends to be relatively price elastic as there are relatively close substitutes available, but each firm is attempting to reduce this price elasticity by producing a brand which is better and more attractive than those of its competitors. In the short run, during the period when new firms cannot enter the market, some firms operating under conditions of monopolistic competition can earn abnormal profits. The graph showing the equilibrium is similar to the one for monopoly - see Figure 3.4 in the previous topic. The only difference would be that demand is more elastic in the case of monopolistic competition as consumers have a choice, which they do not have in monopoly, so the revenue curves will have slightly flatter slopes. But, since barriers to entry are low, in the long run firms will earn normal profits as new firms enter the market to compete. Figure 4.1 shows the long-run equilibrium output of a firm operating under conditions of monopolistic competition. Note however that some firms may, by clever design and branding, be able to make their demand curve (average revenue) more inelastic and to be able to sell more at a higher price, thus continuing to earn some abnormal profit. They are able to do this because they can create perceived advantages for their own brand, but these may be more imagined than real; advertising and marketing techniques help each firm to achieve these product advantages. The effect on customers is negative because they are paying a higher price for a product which may not be any better than others which are cheaper. The price is also higher because the firm has to cover its advertising expenses. However, consumers benefit because there is a variety of products available in the market as a whole and consumers may be prepared to pay for this choice. In terms of the efficiency of this market structure, note also that the firm is not productively efficient because it is not operating at the lowest point of the average cost curve. Equally, it is not allocatively efficient either because its price exceeds marginal cost.

Short-run equilibrium in a perfect market

We will describe Figure 3.1 in some detail as it is the first time you have studied this type of graph. First, look back at Unit 6 Topic 4 to make sure that you understand why the average cost and marginal cost curves are U-shaped and why the marginal cost curve cuts the average cost curve at its lowest point. You have also learned in Unit 6 Topic 3 that the average revenue curve faced by a firm is the demand curve. This normally has a negative slope, i.e. it is downward-sloping from left to right. The marginal revenue curve also has a negative slope but is positioned below the average revenue curve (see Figure 3.3). But in a perfect market, demand is perfectly elastic and so the firm faces a horizontal demand curve - you learned this in the first half of the course. Since every unit is sold at the same price as every other unit, marginal revenue is always equal to average revenue and so the same demand curve (line) represents both average revenue and marginal revenue; this is also the price. In Figure 3.1 you will notice that the AC and MC curves are positioned low in the graph and the point where AC = MC is below the AR = MR line. This is either because market factors are making it possible for firms to keep their costs low and/or because demand and revenues are higher than costs. The firm in the diagram maximises profits at the point where MC = MR - this is at point Q1, where the vertical line meets the output axis. The horizontal line at this point is also the AR = MR line and this shows that the firm is charging price P1 at output Q1. We can now calculate the profit being made by this firm at the equilibrium price and output by calculating total revenue and total cost and subtracting the latter from the former. Total revenue = average revenue × output and this is represented by the rectangle 0Q1C P1 on the graph. TR = AR × Q Total cost = average cost x output and this is represented by the rectangle 0Q1AB on the graph. TC = AC × Q The difference between total revenue and total cost is profit, represented by the shaded area BAC P1. Profit = TR - TC You will also remember from Section 6 Topic 5 that, in economics, normal profit is regarded as a cost of production and that a firm earns normal profit where AR = AC, or to put it another way, where TR = TC. As explained above, TR is greater than TC and the difference represented by BACP1 is abnormal profit. This firm is doing well and earning supernormal profits. But this is a perfect market and there are no barriers to entry. When other firms see this abnormal profit, they enter the market immediately to compete and to absorb this profit. In Figure 3.2, a lot of new firms have come into the market to compete and this has either caused costs to rise or revenue to fall, or both. Costs could rise as firms spend more money on advertising their products; revenue could fall as firms have to reduce their price in order to sell more units. In this case, the AC and MC curves are above the AR = MR line. Total revenue = 0Q1A P1 Total cost = 0Q1CD The difference is a loss of P1ACD. Firms which are making a loss, like this one, will immediately leave the market.

Monopsony

While a monopoly is a single seller, a monopsony is a firm which is the only buyer in the market, although there may be many sellers. It is actually rare to find one organisation which is the only buyer of a product but some firms do buy a large percentage of the market. For example, the National Health Service is a major buyer of pharmaceuticals in the UK and a major buyer of the labour of nurses and doctors. (You will learn about monopsony of labour in Section 8.) Supermarkets are major buyers of grocery products, although none controls the whole market. Having considerable buying power means that a monopsonist can drive the price paid to suppliers down below that which would exist in a market with more buyers. Other things being equal, this in-creases the monopsonist's profits while squeezing the profit of the supplier. The effect on the price paid by consumers will depend on the extent to which the monopsonist passes on the lower costs to them in the form of lower prices. There may be a lower supply of the product available to consumers as a result of the monopsonist paying a lower price, although this too depends on the extent to which suppliers can find other buyers in other markets.

Decide which of the following industries may be regarded as operating in contestable markets. - Banking - Steel - Housebuilding - Oil refining - Plumbing - Window cleaning

Window cleaning. Traditional window cleaners had only to invest in a ladder, bucket and sponge and the sunk costs are insignificant. However, modern window cleaners use vans which are specially equipped with hot water and hoses and this is a much more expensive investment. You might have said plumbing, although the cost of training to be a plumber is quite high; it is a non-transferable skill and is therefore a sunk cost.