Market Structures | 4.1.5 | Microeconomics | AQA A-Level Economics Notes

Last updated on Feb 12, 2024

4.1.5.1 Market Structures

There is a spectrum of market structures ranging from perfect competition to pure monopoly.
Certain factors are used to distinguish between different market structures: number of firms, degree of product differentiation, and ease of entry.

4.1.5.2 The Objectives of Firms

The models that comprise the traditional theory of the firm are based upon the assumption that firms aim to maximise profits.
Profit maximisation occurs when MC = MR.
Owners are shareholders and want to maximise profits and their dividends.
Managers and workers are in control and also have a better idea of want consumers want. The government can also influence prices.
The principal-agent problem occurs because owners may have imperfect information about the objectives of managers (for example, managers may want to maximise enjoyment).
This problem is sometimes overcome by incentives; e.g. the agent bears the cost of not fulfilling a task delegated by the principal, but not the full benefits. If it was the other way around, the agent may take more risk or put in less effort for personal gain.
Other problems with profit maximisation: firms have imperfect knowledge of MC = MR, they can be investigated for charging higher prices, profits may not be shared equally e.g. in a monopsony.
Firms have a variety of other possible objectives including survival, growth, quality maximising their sales revenue and increasing their market share.
Revenue maximisation can mean lower prices that will drive out competition. It can also lead to an increase in the size of firms, leading to economies of scale, future profits and investment.
Sales maximisation: AC = AR (non-profit organisations, monopolies to drive out competitors)
Revenue maximisation: MR = 0 (gain consumer loyalty through sales, push competitors out, economies of scale).
When there is a divorce of ownership from control, the profit-satisficing principle is considered.
Workers and managers may not get the same reward from maximising profits as owners do, so they generate the minimum level of profit to keep shareholders happy, whilst maximising other objectives (enjoying work, getting along with workers).

4.1.5.3 Perfect Competition

In perfect competition, firms are profit maximisers, but abnormal profits only exist in the short-run. Due to free entry, new firms enter upon seeing abnormal profit and hence supply shifts to the right. This causes the price to fall, so there are no profits in the long-run. Prices have no tendency to change in the long run due to the ‘no sales, no sense’ theory.
Perfect markets operate at the point at which MC = AC, so there is productive efficiency. Low prices lead to allocative efficiency, but not dynamic efficiency.
A perfectly competitive market is defined by a large number of producers, identical products, freedom of entry and exit, and perfectly knowledge.
Perfect competition, in both product and labour markets, provides a yardstick for judging the extent to which real world markets perform efficiently or inefficiently, and the extent to which a misallocation of resources occurs.
Perfectly competitive markets only lead to an efficient allocation of resources, given certain assumptions such as a lack of externalities.

4.1.5.4 Monopolistic Competition

Monopolistically competitive markets are defined by product differentiation and non-price competition, giving firms some degree of price making power. Barriers to entry and exit are low and firms aim to profit maximise.
Demand is relatively elastic due to high competition, but not perfectly elastic due to products varying slightly.
Monopolistically competitive markets show no allocative, dynamic or productive efficiency. P > MC, and there are not enough profits in the long run to invest.
In the short run, MC = MR as firms profit maximise. When there are supernormal profits, new entrants are attracted so supply increases. When there is an increase in the number of firms and supply in the industry, the demand and the AR curve for the individual firm shifts to the left. At this point, firms still operate at MC = MR (long-run) but there is no profit to be made.
Firms will try to stay in the short run by innovation, and further differentiating products.
Pros: markets are contestable, differentiation and diversity, more efficient outcomes than monopoly.
Cons: differentiation/ non-price competition generates advertising/ packaging waste, allocative and productive inefficiency.

4.1.5.5 Oligopoly

Oligopoly markets consist of high barriers to entry and exit, product differentiation, interdependence of firms, price wars and non-price competition. They have few firms with a high concentration ratio.
Oligopoly markets can be very different in relation to, for example, the number of firms, the degree of product differentiation and ease of entry.
Oligopoly can be defined in terms of market structure or in terms of market conduct (behaviour). Oligopolies can therefore be collusive or competitive.
A concentration ratio is the net market share held by the top x firms.
Collusive oligopoly can be seen by market characteristics such as: fewer firms, each firm has similar costs, high entry barriers, ineffective competition policy, consumer loyalty and consumer inertia.
A cartel is a collusive agreement by firms, usually to fix prices.
Competitive/ non-collusive oligopoly markets have: large no. of firms, possible market entry through innovation, saturated market, and one firm with a significant cost advantage.
These factors can influence price, output and investment (research and advertising) in oligopolistic industries.
Game theory shows us that collusion can lead to higher profits, due to certainty.
Tacit collusion is informal (price leadership and price wars).
Overt collusion involves formal, usually secret, agreements among competitors.
Cooperation, or some forms of overt collusion, in the full public view, can be good for the industry (e.g. Ford and VW aiming to improve health and safety).
The Kinked Demand Curve Model is a model of oligopoly that illustrates the interdependence between firms in oligopoly markets. It shows that, when there are few firms in the market, raising the price will lead to a huge reduction in demand, whilst decreasing prices will lead to a very small, only temporary rise in demand as other firms will react by lowering their prices, hence price has no tendency to change.
Price leadership: the setting of prices in a market, usually by a dominant firm.
Price agreement: an agreement between firms regarding the pricing of a good.
Price wars occur when rival firms continuously lower prices to undercut each other.
Non-price competition: innovation, quality of service, upgrades and discounts, promotions, branding and advertising, loyalty gifts.
Barriers to entry are obstacles that make it difficult for a new firm to enter a market. They can be structural (specific to industries e.g. start-up/ capital costs), strategic (anti-competitive practises) or statutory (legal barriers include patents and licenses).
Barriers to entry include economies of scale, start-up costs, legal barriers, branding/ advertising (loyalty) and sunk costs.
Sunk costs: costs that have already been incurred and cannot be recovered.
Limit prices: prices set low enough to make it unprofitable for other firms to enter the market.
Predatory prices: prices set below average cost to force rival firms out of business.
Market conduct refers to how firms behave in oligopolistic markets, but market performance relates to the outcomes of these actions. We can evaluate oligopoly outcomes by referring to monopoly and competitive outcomes, depending on the state of the oligopoly.
Collusion may allow oligopolists to act as a monopolist and maximise their joint profits.

4.1.5.6 Monopoly and Monopoly Power

A pure monopoly is a sole seller in a market.
Firms operating in monopolistically competitive and oligopolistic markets are price makers and have varying degrees of monopoly power.
Monopoly power is influenced by factors such as barriers to entry, the number of competitors, advertising and the degree of product differentiation.
The basic model of monopoly suggests that higher prices and profits will lead to a misallocation of resources compared to in a competitive market.
Monopolies exploit customers by charging higher prices. This means the goods and services they provide are under-consumed, and consumers’ needs and wants are not met.
Monopolies have no incentive to improve efficiency as production costs are high due to a lack of competition. There is a loss of consumer surplus and a gain of producer surplus.
Monopolies have the benefits of being able to exploit economies of scale, leading to lower average costs of production in the long run.
Extra abnormal profits can also be used for investment and innovation or research and development, leading to dynamic efficiency gains in the long run.

4.1.5.7 Price Discrimination

Price discrimination occurs when different consumers are charged different prices for the same product or service, often with prices based on different willingness to pay.
Three conditions: it must be possible to identify different groups of customers or sub-markets for the product, at any given price – different consumers must show different elasticities of demand and the markets must be able to prevent seepage (consumers buying at lower prices and selling to others).
First-degree price discrimination occurs when all consumers are charged the exact price they are willing to pay, up to the equilibrium price, meaning there is no consumer surplus at all. This does not exist in the real world.
Second-degree price discrimination occurs when prices are dropped in the case of excess supply (e.g. to sell of remaining train tickets).
Third-degree price discrimination occurs when different groups of consumers show different PEDs. This is also known as market segmentation and is arguably the most common type of price discrimination in the real world.
Pros: firms will be able to maximise revenue, enabling some firms to stay in business, profits can be used for research, development and investment, and some consumers will also benefit from lower fares (e.g. elderly discounts).
Cons: consumer surplus falls, some consumers are exploited and pay higher prices, loss of allocative efficiency (P>MC), administration costs for firms, profits could be used to finance anti-competitive behaviour.

4.1.5.8 The Dynamics of Competition and Competitive Market Processes

Pros: there is perfect knowledge and no risk of information failure, firms cannot exploit monopoly power, maximum consumer surplus and economic welfare, no advertising costs due to perfect knowledge, maximum allocative and productive efficiency, P = MC in the short run and long run, and MC = ATC in the long run, maximum choice for consumers.
Cons: very unrealistic model, question of whether producers and consumers act as rationally as model suggests (behavioural economics), lack of profits, no opportunity for investment or dynamic efficiency gains.
Firms do not just compete on the basis of price but competition will, for example, also lead firms to strive to improve products, reduce costs, and improve the quality of the service provided.
If firms have monopoly power and are making large profits, over time there will be an incentive for new firms to enter the market and to innovate to overcome the existing barriers to entry.
Creative destruction is a fundamental feature of the way in which competition operates in a market economy.
Creative destruction refers to capitalism evolving and renewing itself through new technologies and innovations replacing older ones.
Creative destruction is arguably a free market solution to inefficiencies.
Pros: Free market economists would argue that, rather than risking government failure, allow unprofitable firms to close down, allowing resources to move into the hands of profitable firms and industries. The threat of going out of business acts as an incentive for incumbent firms to keep costs low and continually invest in development.
Cons: structural unemployment, external benefits of previous industries ignored (e.g. railways closed down would have prevented road congestion and pollution), regional unemployment, (winners and losers), further inefficiencies of closure and job losses/ redistribution of resources.

4.1.5.9 Contestable and Non-contestable Markets

Contestability is significant for the performance of an industry.
A contestable market consists of free entry and exit, a pool of potential entrants, perfect information, and incumbents being vulnerable to ‘hit and run’ competition.
Hit-and-run competition occurs when entrants can join a market, make profits and leave.
If a monopoly market becomes more contestable, output will increase and prices will fall.
Sunk costs are costs that cannot be recovered, acting as a barrier to exit, particularly in incontestable markets.
The threat of costless entry of new firms will incentivise businesses to minimise costs.
Point B, below shows the entry-limit price. Firms push costs down to a sales-maximisation price of AR = AC. Normal profit deters new entrants.

4.1.5.10 Market Structure, Static Efficiency, Dynamic Efficiency and Resource Allocation

Static efficiency is efficiency at a particular point in time.
Dynamic efficiency occurs in the long run, leading to the development of new products and more efficient processes that improve productive efficiency.
Productive efficiency occurs at the level of output at which average costs of production are minimised (MC = AC).
Allocative efficiency occurs when it is impossible to improve overall economic welfare by redistributing resources between markets (P = MC).
Dynamic efficiency is influenced by, for example, research and development, investment in human and non-human capital and technological change.
Technical efficiency occurs when firms can maximise the output from a given quantity of inputs/ factors of production.
X-inefficiency occurs when firms have no incentive to cut costs.
Pareto efficiency occurs when resources are distributed in the most efficient way. This means we are in a situation where it is impossible to make one person better off without making someone else worse off.

4.1.5.11 Consumer and Producer Surplus

Consumer surplus is a measure of the economic welfare enjoyed by consumers. It is the surplus utility received over and above the price paid for the good.
Producer surplus is a measure of the economic welfare enjoyed by firms/ producers. It is the difference between the price the firm is able to charge and the minimum price it would be prepared to accept.
Deadweight loss refers to a loss of economic welfare when the maximum attainable level of total welfare is not achieved.