A2 Economics – Microeconomics revision notes

Chapter 2
Perfect competition

 Many buyers and sellers  neither of which can influence the price  there are no price takers
o From seller perspective this is tantamount to saying that there are limited economies of scale in the
industry
o If the minimum efficient scale is small relative to market demand  no firm is likely to become so
large that it will gain influence in the market
 There are no barriers to entry or exit
o Firms are able to join the market if they perceive it as profitable step and can exit without hindrance
o This assumption is important when it comes to considering the long-run equilibrium towards which
the market will tend
 There is perfect knowledge or information
o Buyers always know the prices that firms are charging and thus can buy the good at the cheapest
possible price
 All firms aim to maximise profit  MR = MC
o Pursuit of self-interest by firms and consumers ensure that the market works effectively
 Homogenous product
o Buyers of the good see all products in the market as identical and will not favour one firm’s over
another
o If there were brand loyalty  the firm would be able to charge a premium on its price
o By ruling out this possibility, the previous assumption is reinforced  no individual seller is able to
influence the selling price of the product
A2 Economics – Microeconomics revision notes
A2 Economics – Microeconomics revision notes
Monopoly
Characteristics
 Single seller  legally it only needs 25% market share to be classed as a monopoly
 No close substitutes  The firm can sell a product that is unique  as a result it can determine price OR
output  it cannot dictate both at the same time as it is constrained by the demand curve
 High barriers to entry or exit
Pure monopoly – Involves one firm dominating the market
Benefits of monopolies
For consumers I – Innovation  Bringing new ideas & processes
R – R&D  Only large firms with monopoly profits
can afford to take such risks
I – Investment  Have confidence that they will
still exist to reap the rewards from an investment
For government T – Tax  Larger firms pay more corporation tax
J – Jobs  Monopoly power helps keep jobs in
country and may improve Balance of Payments
For workers J - Jobs  Monopolies may offer better job
security
B – Bonuses  Higher profits for monopolies may
mean higher bonuses/more perks
For other firms O – Secure outlet  They can offer a secure outlet
such as suppliers for suppliers
Q – Quality  Firms which buy from monopolies
might be more likely to have consistent quality
Costs of monopolies
C – Less Choice  Large firms keep to the
brands which make the most profit
P – Higher prices  Monopolists can increase
price to maximise their profits
Q – Lower quality  No competition,
therefore no incentive to provide a good
service or produce better products
T – Tax avoidance  Monopolies can find it
easy to avoid paying tax and can employ
expensive tax consultants to help them do so
B – Bargaining power  It might not be easy
to transfer to a similar company as there is
only one in the industry
J – Job security  Monopolies don’t
guarantee jobs security, monopoly profits can
be invested in machinery which replaces
workers
E – Exploitation  Small computer outlets
may be exploited as they may have no choice
over range and price e.g. with Apple products
P – Predatory pricing  Other firms can be
forced out of the market through predatory
pricing because they have not yet established
themselves
A2 Economics – Microeconomics revision notes
A2 Economics – Microeconomics revision notes
Price discrimination by a monopoly firm

Three conditions 
1. There are different submarkets with different price elasticities of demand
2. Consumers cannot move between the submarkets  there is no ‘arbitrage’  creating a secondary market
3. The cost of keeping the markets separate is less than the increased profits gained from so doing
4. The firm must have a high degree of monopoly power

Third degree price discrimination  Charging different groups of consumers a different price for the same product
or service

Summary 

First degree or perfect price discrimination

 Charging every consumer what they are willing to pay e.g. Ebay, on-line auction
Second degree price discrimination
 Charging a consumer a different price depending on the volume hey buy, this is seen particularly with
industrial sector  bulk-buying discount

Monopsony
A2 Economics – Microeconomics revision notes
Pure monopsony  a firms which is the sole buyer of resources or supplies
 Many firms have some degree of monopsony, which means firms have some control over their suppliers

Benefits Costs
Firms and  Power in buying means the firm can make more profits as  Suppliers can be squeezed out
consumer suppliers cannot overcharge of business
s  Lower buying costs might be passed on to the consumer in  Choice for consumers could be
retail prices limited, as monopsony acts as
 Higher profits of monopsony can be used to invest and a barrier to entry for new firms
innovate  Higher profits of monopsony
 Monopsony power can give power to buyers in the face of can mean inequality
monopoly supply of resources  Firms might be investigated by
o Cosmetic producers e.g. L’Oréal can charge very high the competition authorities
prices for their products but monopolistic
supermarkets can force them to cut their costs

Monopolistic competition

Assumptions 

 Many small firms – same as perfect competition

 Many individual buyers – same as perfect
competition
 Freedom of entry and exit  same as perfect
competition
 Imperfect knowledge  firms may advertise to
differentiate
 Non-homogenous products  demand is elastic
as many goods are substitutes and each firm
retains some brand loyalty
A2 Economics – Microeconomics revision notes

Evaluating monopolistic competition

 Lots of choice for consumers  all goods are differentiated

 No firm producing at productively efficient point  so not exploiting economies of scale
 Allocative efficiency as P=MC  consumer is willing to pay price that it costs to produce one more
 Use of advertising to differentiate product is wasteful
A2 Economics – Microeconomics revision notes
Oligopoly

Assumptions 
 The firms are interdependent  action of one firm is dependent on the actions of another  a firms
decisions on price, output and other competitive activities can have immediate effects on competitors
 Firms face a downward sloping demand curve
 Firms aim for profit maximisation  MR = MC
 A few firms dominate the market & barriers to entry and exit are high

Game theory  we can use this to analyse the point above on interdependence

High price Low price Pay-off matrix  a simple two-firm, two outcome model

Prisoner’s dilemma  a model used in GT to question whether

High price 100 160 firms might not collude even though they should

100 0
Non-Collusive  behaviour occurs when firms act in a way that
Low price 0 80 does not involve collaboration with other players in the market
 the kinked demand curve theory explained below provides
160 80 an example

 When they both charge a high price they make a supernormal profit  £100  TR>TC
 R under cuts  now get 160 but Q get 0  this in turn leads to Q cutting prices  now only 80-80

Pricing strategies used in Oligopoly  Price, predatory, limit, leadership & non-price competition

Price wars  Occurs when price cutting leads to retaliation and other firms cut prices  leads to further cuts
made by the original firm to increase sales  can be destructive for all firms involved

Predatory pricing  Firms cut prices below average cost of production (Also may mean prices are below AVC)  it is
a short-term measure only and pushes other firms out of the market  almost always illegal

Limit pricing  cutting prices to the point where possible entrants or higher-cost firms cannot compete  the
incumbent firm can sustain this position in the long term because it has lower costs  may or
may not be illegal depending on the specific cases looked at by the competition authorities

Price leadership  Dominant firm acts to change price and other firm follow  if other firms try to make changes
this could set off a price war or other sorts of retaliation  the larger firms becomes the
established leader e.g. Barclays  price leader when setting inter-bank borrowing rates

Non-price competition  firms take action to compete without changing prices  maybe through advertising
loyalty cards, free gifts or similar strategies

Evaluation of non-price competition

 Non price competition costs money and pushes marginal and average costs up  reducing profits
 May only maintain market share
 Across an industry money spent on non-price competition is often seen as a waste/loss of welfare
 A2 Economics – Microeconomics revision notes

WHEN TALKING ABOUT NON-COLLUSIVE BEHAVIOUR STATE BRAND LOYALTY REDUCES PED

Collusion  occurs when firms operate together or collaborate

Overt collusion  overt collusion occurs if a firm sends messages to another firm about its prices or other decisions
in order to maximise profits it is illegal and easier to detect than tacit collusion as it is open (Overt)  they are
unstable organisations because there is an underlying incentive to cheat on the collusion agreement to get a short-
term agreement  Competition commission can fine firms 10% of revenue each year cartel was in existence

Tacit collusion  an implicit (Suggested though not directly expressed) understanding might operate between firms
without communication or written agreement this is illegal but very hard to for the competition authorities to
control  auction example  this may happen through price leadership (Dominant firm sets price) or barometric
price leadership --. Firm tries a higher price to see if others follow, if they do not they drop their price again

Kinked demand theory  can be used to explain behaviour of oligopolistic firms

 The response to cutting or raising prices of one firm to another firm depend on the PED of the goods or
service  Necessities are price inelastic therefore if one firm raises prices, others will not  if one firm
lowers price, all other firms will
 Neither action (Increase or decreasing prices) leads to an increase in total revenue
 This model explains why it may look as if firms are colluding even though they are not

Evaluation of the model 

 The model does not explain why prices are what they are in the first place
 It only explains some degree of stability and some markets are far more complex
 A pay-off matrix gives a far wider range of possibilities and explains cartels and collusions
 The model can provide some game theory analysis when required

In theory the abnormal profits do not get competed away in the long run
because there are barriers to entry preventing new firms entering
A2 Economics – Microeconomics revision notes

Game theory: In-depth explanation

Prisoner’s dilemma 

Nash equilibrium  solution concept of a non-cooperative game involving two or more players, in which each player
is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing
only their own strategy (After knowing your rivals decision you would not change yours)

Dominant strategy  the player’s best strategy independent of the choices of others e.g. agree to confess in case of
prisoners dilemma

Game theory relevance to Oligopoly 

 Two large firms in an oligopoly make decisions based on the reactions of their rivals  their decisions are
independent

Firm A

Lower prices Keep prices

Firms B Lower prices -£1 -£1 +£4 -£3

million million million million
Keep prices -£3 +£4 +£2 +£2
million million million million

 Best strategy  both firms keep prices the same  this maximises joint profits
 Dominant strategy  lower prices  if they both follow dominant strategy they will both lose
 Oligopoly game is not a one-off game  if one firm lowers price then they can expect the other firm to
respond similarly next time  this can lead to a price war  price war = both firms continue to lose

First-mover advantage 

The first firm can construct barriers to

entry

Potential rivals may be

discouraged from committing the
resources necessary to compete
successfully

Second-mover advantage 

Can avoid and learn from the mistakes made by the

first mover
A2 Economics – Microeconomics revision notes

Contestability

Contestability  measure of the ease with which firms can enter or exit an industry

Signs that contestability is low 

 High barriers to entry and exit make a market less contestable
 Sunk costs are the key reason for low contestability  any costs which cannot be recouped such as goodwill
reduce contestability
 High level of competitiveness may be a sign that barriers to entry are low  however a monopoly can also
be contestable if it is the only firm in an industry that no other firm wishes to enter because profits are low
 A high level of concentration is a sign that contestability is low

Signs that contestability levels are high 

 Low levels of supernormal profits
 Low barriers to entry or exit
 Low concentration ratios
 Low sunk costs
 Low levels of collusions or other signs if oligopoly
 New firms entering or leaving the market