Download 8. Efficiencies and Market Structures

Hand-out 8: Efficiencies
and Market Structures
Specification
-The concept of an efficient market structure in terms of costs, prices, output and profit
-The models of market structure:
 monopoly;
 oligopoly;
 monopolistic competition.
Key Concepts
You need to be able to:
 Define the different efficiencies and apply to 3 market structures
 Explain the impact of competition / concentration on efficiencies
 Draw each of the market structures diagrammatically
 Explain each market structure diagram analytically
 Evaluate the impact that more or less competition will have on a market in terms
of efficiency
Allocative Efficiency
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Allocative efficiency occurs when consumers pay a market price that reflects
the private marginal cost of production. The condition for allocative efficiency for
a firm is to produce an output where marginal cost, MC, just equals price, P. We
can show it on a diagram where MC = AR.
Productive Efficiency
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Productive efficiency occurs when a firm is combining resources in such a way as
to produce a given output at the lowest possible average total cost. Costs will be
minimised at the lowest point on a firm's short run average total cost curve.
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This also means that AC = MC, because MC always cuts ATC at the lowest point
on the ATC curve.
Dynamic Efficiency
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The concept of dynamic efficiency is commonly associated with the Austrian
Economist Joseph Schumpeter and means technological progressiveness and
innovation.
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Firms that are highly protected are more likely to undertake risky innovation, and
generate dynamic efficiency. Firms can reinvest supernormal profits to cement
their dominant market position.
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Firms can benefit from two types of innovation:
1. Process innovation occurs when new production techniques are applied to
an existing product. For example, this is common in the production of motor
vehicles with firms constantly looking to develop new methods and
production processes.
2. Product innovation occurs when firms generate new or improved products.
For example, this is common in many consumer product markets, including
electronics and communications.
X Efficiency
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X efficiency can be applied specifically to situations where there is more or less
motivation of management to maximise output, or not.
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X efficiency occurs when the output of firms, from a given amount of input, is the
greatest it can be. It is likely to arise when firms operate in highly competitive
markets where managers are motivated to produce as much as possible.
Monopoly
A pure monopoly is a single supplier in a market. For the purposes of regulation,
monopoly power exists when a single firm controls 25% or more of a particular market.
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Monopolies can maintain super-normal profits in the long run.
Monopolies are profit maximisers and produce where MC = MR.
Monopolies are the single sellers of a product,
There is a lack of close substitute goods
Hence in a pure monopoly there is zero competition.
At profit maximisation, MC = MR, and output is Q and price P. Given that price
(AR) is above ATC at Q, supernormal profits are possible (area PABC).
High barriers to entry and exit prevent competitors from entering the market
They are not allocatively efficient (production is not where MC = AR / P)
They are not productively efficient (Q is lower than where MC = AC)
Not X efficient
There is an argument to say that monopolies may be dynamically efficient
Evaluation of monopolies
The advantages of monopolies:
Monopolies can be defended on the following grounds:
1. They can benefit from economies of scale, and may be ‘natural’ monopolies, so
it may be argued that it is best for them to remain monopolies to avoid the
wasteful duplication of infrastructure that would happen if new firms were
encouraged to build their own infrastructure.
2. Domestic monopolies can become dominant in their own territory and then
penetrate overseas markets, earning a country valuable export revenues. This is
certainly the case with Microsoft.
3. According to Austrian economist Joseph Schumpeter, inefficient firms, including
monopolies, would eventually be replaced by more efficient and effective firms
through a process called creative destruction.
4. It has been consistently argued by some economists that monopoly power is
required to generate dynamic efficiency, that is, technological progressiveness.
This is because:
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High profit levels boost investment in R&D.
Innovation is more likely with large enterprises and this innovation can lead to lower
costs than in competitive markets.
A firm needs a dominant position to bear the risks associated with innovation
Firms need to be able to protect their intellectual property by establishing barriers to
entry; otherwise, there will be a free rider problem.
Why spend large sums on R&D if ideas or designs are instantly copied by rivals who
have not allocated funds to R&D?
However, monopolies are protected from competition by barriers to entry and this
will generate high levels of supernormal profits.
If some of these profits are invested in new technology, costs are reduced via
process innovation. This makes the monopolist’s supply curve to the right of the
industry supply curve. The result is lower price and higher output in the long run.
The disadvantages of monopoly to the consumer:
Monopolies can be criticised because of their potential negative effects on the
consumer, including:
1. Restricting output onto the market.
2. Charging a higher price than in a more competitive market.
3. Reducing consumer surplus and economic welfare.
4. Restricting choice for consumers.
5. Reducing consumer sovereignty.
Oligopoly
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated.
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Interdependence: Firms that are interdependent cannot act independently of
each other. A firm operating in a market with just a few competitors must take
the potential reaction of its closest rivals into account when making its own
decisions.
Barriers to entry: Oligopolies and monopolies frequently maintain their position of
dominance in a market might because it is too costly or difficult for potential
rivals to enter the market.
Collusion: Another key feature of oligopolistic markets is that firms may attempt
to collude, rather than compete. If colluding, participants act like a monopoly
and can enjoy the benefits of higher profits over the long term.
Competition: When competing, oligopolists prefer non-price competition in order
to avoid price wars. A price reduction may achieve strategic benefits, such as
gaining market share, or deterring entry, but the danger is that rivals will simply
reduce their prices in response.
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Firms face a kinked demand curve
Price rigidity/stickiness
Non-price competition being used
Evaluation of Oligopolies:
Oligopolies are significant because they generate a considerable share of the UK’s
national income, and they dominate many sectors of the UK economy.
The disadvantages of oligopolies
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High concentration reduces consumer choice.
Cartel-like behaviour reduces competition and can lead to higher prices and
reduced output.
Firms can be prevented from entering a market because of deliberate barriers to
entry. There is a potential loss of economic welfare.
Oligopolists tend to be allocatively and productively inefficient.
The advantages of oligopolies
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Oligopolies may adopt a highly competitive strategy, in which case they can
generate similar benefits to more competitive market structures, such as lower
prices. Even though there are a few firms, making the market uncompetitive,
their behaviour may be highly competitive.
Oligopolists may be dynamically efficient in terms of innovation and new
product and process development. The super-normal profits they generate may
be used to innovate, in which case the consumer may gain.
Price stability may bring advantages to consumers and the macro-economy
because it helps consumers plan ahead and stabilises their expenditure, which
may help stabilise the trade cycle.
Monopolistic Competition
The model of monopolistic competition describes a common market structure in which
firms have many competitors, but each one sells a slightly different product.
Many small businesses operate under conditions of monopolistic competition, including
independently owned and operated high-street stores and restaurants. In the case of
restaurants, each one offers something different and possesses an element of
uniqueness, but all are essentially competing for the same customers.
Monopolistically competitive markets exhibit the following characteristics:
1. Each firm makes independent decisions about price and output, based on its
product, its market, and its costs of production.
2. Knowledge is widely spread between participants, but it is unlikely to be perfect.
3. There is freedom to enter or leave the market, as there are no major barriers to
entry or exit.
4. A central feature of monopolistic competition is that products are differentiated.
There are four main types of differentiation:
 Physical product differentiation,
 Marketing differentiation
 Human capital differentiation,
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Differentiation through distribution, including distribution
5. Firms are price makers and are faced with a downward sloping demand curve.
Because each firm makes a unique product, it can charge a higher or lower
price than its rivals. The firm can set its own price and does not have to ‘take' it
from the industry as a whole.
6. Firms operating under monopolistic competition usually have to engage in
advertising.
7. Monopolistically competitive firms are assumed to be profit maximisers
8. There are usually a large numbers of independent firms competing in the market.
Diagram:
In the short run supernormal profits are possible, but in the long run new firms are
attracted into the industry, because of low barriers to entry, good knowledge and an
opportunity to differentiate. The diagram is the same as a monopoly.
Monopolistic competition in the long run
Super-normal profits attract in new entrants, which shifts the demand curve for existing
firm to the left. New entrants continue until only normal profit is available. At this point,
firms have reached their long run equilibrium.
Clearly, the firm benefits most when it is in its short run and will try to stay in the short run
by innovating, and further product differentiation.
Evaluation
Monopolistic competition can bring the following advantages:
 There are no significant barriers to entry; therefore markets are relatively
contestable.
 Differentiation creates diversity, choice and utility.
 The market is more efficient than monopoly but less efficient than perfect
competition - less allocatively and less productively efficient. However, they may
be dynamically efficient, innovative in terms of new production processes or new
products.
There may be the following disadvantages:
The disadvantages of monopolistic competition:
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Some differentiation does not create utility but generates unnecessary waste,
such as excess packaging. Advertising may also be considered wasteful, though
most is informative rather than persuasive.
As the diagram illustrates, assuming profit maximisation, there is allocative
inefficiency in both the long and short run.
This is because price is above marginal cost in both cases. In the long run the firm
is less allocatively inefficient, but it is still inefficient.
There is a tendency for excess capacity because firms can never fully exploit
their fixed factors because mass production is difficult. This means they are
productively inefficient in both the long and short run. However, this is may be
outweighed by the advantages of diversity and choice.
Past Paper Questions
Topic
The concept of an efficient
market structure in terms of
costs, prices, output and
profit.
The models of market
structure:

monopoly;

oligopoly;

monopolistic
competition.
Questions
Discuss the extent to which a monopoly provider of transport will always increase
economic efficiency. (20 marks) (Jan 2010)
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Analyse, using a diagram, the market structure of a monopoly. (15 marks)
(June 2010)
Analyse the difference between the short run and long run equilibrium of the
firm in monopolistic competition. (15 marks) (Jan 2011)
Analyse the main characteristics of an oligopolistic market. (15 marks) (Jan
2012)
Analyse the characteristics of monopolistic competition. (15 marks) (June
2012)