What are the different types of efficiency?

Efficiency occurs when scarce resources are optimally produced and distributed within a market. The different types of efficiency are:

1. Allocative efficiency occurs when all goods and services are optimally distributed among buyers in an economy, maximising social welfare. Every good or service is produced up to where the last unit provides a marginal benefit to the consumer equal to the marginal cost of producing it. The condition of allocative efficiency is where P=MC.
2. Productive efficiency occurs when a firm produces at the lowest average cost possible. This is where firms produce at the bottom of the AC curve, where MC=AC. 
3. Dynamic efficiency is the effective distribution of resources over time, emphasising continual adaptation and innovation for long-term growth.  
4. X-inefficiency occurs when firms operate below their potential efficiency. It is where the firm's average cost is above where it should be on the average cost curve at a given output level.

The levels of efficiency and/or inefficiency within a market are discussed later in this article.

What are the characteristics of perfect competition?

Perfect competition is a theoretical model where there exists lots of buyers and sellers trading homogenous products with no barriers to entry or exit and where no participant has the ability to change market prices. 

There are 5 main characteristics.

1. Lots of buyers and sellers. This is so that no individual participant has any influence on prices. 
2. Freedom of entry and exit. This allows new competitors to easily enter the market when there are profits to be made, driving down prices to production cost levels. Freedom to leave the market allows firms to easily leave when market conditions change.
3. Perfect knowledge. This enables market participants to make fully informed and rational decisions. All buyers and sellers are completely aware of prices, product quality, costs and alternatives. This allows easy comparison of prices so that resources are allocated efficiently.
4. All firms produce homogenous products. This ensures that consumers don't see any difference between the goods and services available. This is so that the goods and services are perfect substitutes so that the consumers make their purchasing decisions on price alone.
5. All firms are price takers. This is because firms lack individual market influence. 

Where is the profit-maximising equilibrium in the short run and the long run in a market in perfect competition including diagrammatic analysis?

In the short run, firms produce at the point where MC=MR and can either make subnormal, normal or supernormal profit. In the example above, the firm is producing at price P where S=D, quantity Q and making supernormal profit. The firm is allocatively efficient (as P=MC), but not productively efficient, as the firm is not producing at the lowest point on the AC curve.

As the market is perfectly competitive, in the long run competitors will enter the market as there are no barriers to entry, perfect information and supernormal profit being made. This will lead to an outward shift in supply from S to S1 and a new price of P1. This shifts the AR=MR curve to AR1=MR1. The firm now produces at quantity Q1 which is less than the original Q. The firm is now making a normal profit and is productively and allocatively efficient. This means that in the long run, firms in perfect competition make a normal profit as competition drives profits to zero.

What are the characteristics of monopolistically competitive markets?

Monopolistic competition is a market structure which blends features of both monopoly and competitive markets. Numerous firms produce slightly differentiated goods, so have some form of market power.

Examples of typical firms in monopolistic competition include cafés, restaurants and takeaways. The characteristics of monopolistically competitive markets are:

1. Many buyers and sellers. This ensures there is no price-setting power, and that no firm exerts substantial market control, ensuring a competitive environment.
2. Differentiated products. Firms produce non-homogenous goods so that they can distinguish their goods and services from rivals. For example through branding, packaging and quality. This creates non-price competition.
3. Freedom of entry and exit. Firms can leave and enter the market relatively easily. 
4. Imperfect knowledge. There is likely to be imperfect knowledge regarding the quality, features and prices of differentiated products.

Where is the profit-maximising equilibrium in the short run and the long run in a market with monopolistic competition including diagrammatic analysis?

In the short run, firms in monopolistic competition can make supernormal, normal or abnormal profits. In the example above, in the short run, the firm in monopolistic competition is producing at MC=MR at price P and quantity Q and making a supernormal profit of the shaded region. The firm is neither productively nor allocatively efficient. 

In the long run, as supernormal profits are being made and there are no barriers to entry, other firms join the industry. This causes a fall in demand and an inward shift of the AR and MR curves to AR1 and MR1 respectively. The firm is now making a normal profit, and producing at a lower price P1 and lower quantity Q1. The firm is neither allocatively nor productively efficient.

What are the characteristics of an oligopoly?

An oligopoly is a market structure where there is a small number of dominant firms that have substantial influence over the market. The main characteristics include: 

1. High barriers to entry and exit. These are typically substantial, such as high start-up costs, patents or control over resources which can help to limit competition.
2. High concentration ratio. This is due to the presence of a few dominant firms with significant control over the industry.
3. Interdependence of firms. The actions of one firm are likely to significantly affect the others. Strategic decisions are likely to trigger a reaction from competitors.
4. Product differentiation. Firms often engage in non-price competition based on product differentiation.

Kinked demand theory suggests that rivals in an oligopoly react in a certain way to price changes, leading to a discontinuity in the demand curve. 

The model shows that there is a tendency towards price stickiness. This is because if a firm in an oligopoly were to raise its prices, others are unlikely to follow suit for fear of losing market share, this is demonstrated with a more elastic demand curve above price P. If a firm in an oligopoly were to lower its prices, competitors are likely to match the price decrease to avoid losing customers. As the price decrease is matched, both firms will lose out, hence the demand curve below price P is inelastic. This creates a kink in demand at the existing price level. Moreover, the gap in the MR curve means that a change in the costs of the firm is unlikely to affect price.

What are n-firm concentration ratios, how are they calculated and what are their significance?

N-firm concentration ratios assess the level of market concentration within an industry. This is found by calculating the percentage of the total market share held in the industry by a specific number of the largest firms. 

For example, a 3-firm concentration ratio would represent the total market share held by the largest 3 firms in the industry. 

The concentration ratio can be found by adding the percentages of the market share of the firms involved. It can also be found by finding the total sales of the firms involved, dividing this by the total sales made in the industry, and then multiplying the answer by 100 to find the answer as a percentage.

N-firm concentration ratios are significant as they can be used to show how concentrated a market is, meaning they are likely to give a good indication of the structure of a market.

What are the reasons for collusive and non-collusive behaviour? 

Collusion occurs when competing firms agree to limit competition in an industry. 

Firms typically collude to make higher profits. They can collectively fix prices at higher levels than they would be in a competitive market and increase their supernormal profits. It may also create more market stability as price wars may be avoided. 

However, collusion is illegal in the UK, and the CMA (Competition and Markets Authority) actively monitors markets to prevent anti-competitive practices and can give out harsh penalties to firms guilty of collusion. There is also the incentive to cheat the collusion agreement by undercutting agreed prices to gain a competitive advantage.

What is overt and tacit collusion, including the concepts of cartels and price leadership?

Overt collusion is when firms come to explicit and direct agreements on how to limit competition. 

Tacit collusion is where collusion occurs but no explicit collusion agreement is made. 

A cartel is a group of firms that collude to limit competition by coordinating their actions to control prices, output and market share for their own benefit. This is typically at the expense of the consumer. Cartels are illegal in the UK.

Price leadership is where one dominant firm or a group of firms within a cartel leads in the setting of prices for a particular market or industry. Other firms in the cartel then follow the price leader and adjust their prices accordingly. This process usually takes place without explicit communication or agreement. This implicit coordination resembles tacit collusion. 

What is simple game theory (prisoner's dilemma in a simple two firm/two outcome model)?

Game theory in economics is a strategic framework which is used to analyse the decision-making of competing firms under the assumption of rationality. 

When using game theory in economics, it's simple to analyse the theory when a duopoly exists in a market such as in the payoff matrix above with Firm A and Firm B. 

To analyse this payoff matrix, it's important to see if Firm A or Firm B has a dominant strategy. A dominant strategy is where the best outcome occurs for the firm regardless of the actions of the other firm. 

In this payoff matrix, there is a dominant strategy for both Firm A and Firm B. For Firm A, their dominant strategy is a price of 90p. This is because no matter what price Firm B sets, Firm A will always earn more at a price of 90p. For example, if Firm B set a price of £1, Firm A could either earn £3 million with a price of £1 or £4 million at a price of 90p. If Firm B set a price of 90p, Firm A could either earn £1 million with a price of £1 or £2 million at a price of 90p. In both cases, Firm A would rather a price of 90p, hence no matter what Firm B sets as their price, Firm A should set their price as 90p. The same also applies to Firm B whose dominant strategy is to set their price at 90p. 

At the price of 90p, both Firm A and Firm B would earn £2 million. If Firm A and Firm B were to collude, they could both agree to set their price at £1. By doing this, they could both make £3 million rather than £2 million. This explains the tendency of firms in an oligopoly to collude, as in this case both Firm A and Firm B could make an additional £1 million simply by raising their prices simultaneously.

However, there is then an incentive to cheat and undercut the other firm. For example, if Firm A and Firm B agreed to fix their prices at £1, Firm A could cheat and lower their price to 90p. Firm A would then earn £4 million. Although Firm B would likely then also change their price to 90p, the two firms are then back to only making £2 million. The firms have reached Nash equilibrium, as neither firm has an incentive to change their price. Hence Nash equilibrium more generally is the point where neither firm has an incentive to change its strategy.

The prisoner’s dilemma is another common example of game theory.

In this example, two people are questioned over whether they committed a crime. They’re kept apart so that they can’t collude. The dominant strategy for both of the prisoners is to confess and receive a 4-year sentence. However, if the prisoners were to collude, the prisoners would both deny the crime and receive a 3-year sentence rather than a 4-year sentence. However, there would be a temptation to cheat on this agreement to collude and hope the other prisoner stuck to the agreement to get no years in prison. The Nash equilibrium would be where both Person A and Person B confess. 

What are the types of price competition? 

1. Price wars normally occur in markets where consumers are more price-conscious and demand is elastic, as firms can gain large amounts of market share by lowering prices. However, this can push firms into a loss, but the firm shouldn't shut down in the short-run as long as AR>AVC.

2. Predatory pricing is where an incumbent firm sets artificial prices to make it financially unviable for smaller firms to survive in the market.

3. Limit pricing is where an incumbent firm sets a low price to make it unattractive for a new firm to enter the market. 

What are the types of non-price competition?

1. Increase in advertising. This creates more awareness of the brand and the goods/services that they sell. 
2. Brand loyalty schemes. These normally include a 'clubcard' which encourages consumers to return and purchase from that producer again rather than from a rival.
3. Quality of goods/services. If a firm produces high-quality or innovative goods and services, this may encourage the consumer to buy from that firm rather than from another firm which sells goods of inferior quality.

What are the characteristics of a monopoly?

A pure monopoly is a single dominant seller of a specific good or service which controls the entire market supply. The monopoly offers a unique good or service and there are very high barriers to entry from entering the market the monopoly dominates. Monopolies may also have the ability to price discriminate. 

Where is the profit-maximising equilibrium in a market with a monopolist, including diagrammatic analysis?

The point of profit maximisation is where MC=MR at quantity Q and price P. This results in supernormal profits of the shaded area. With a monopoly, there is also a welfare loss triangle labelled L on the diagram. The monopoly is both productively inefficient as it is not operating at its lowest possible average cost on the AC curve, and allocatively inefficient as P>MC.

What is third-degree price discrimination? 

Third-degree price discrimination occurs when a seller charges different prices to different consumer groups or market segments for the same product for reasons not associated with costs of supply, but on varying price elasticities of demand.

To price discriminate, the required conditions are that:

• The firm has some degree of monopoly power. 
• Able to segment different consumer groups with different PED values. 
• The firm must be able to prevent seepage between markets. 

A common example of third-degree price discrimination is with 'peak' and 'off-peak' train tickets. Those travelling during 'peak' times usually display very inelastic demand as commuters during peak hours have limited alternatives or substitutes to train travel.

In the combined market, where third-degree price discrimination is not taking place, under the profit maximising condition of MC=MR, a firm would produce at price P2 and quantity Q2, making a supernormal profit of area C. However, when the firm segments its market into the inelastic and elastic markets, holding average cost at AC and marginal cost at MC, the firm would make a supernormal profit of area A+B. This area is much larger than area C, hence practising third-degree price discrimination would help the firm to earn more supernormal profit. Consumers in the elastic market may benefit from a lower price of P1 than they would have to pay in the combined market (P2), however consumers within the inelastic market may have to pay a higher price (P) than they would in the combined market (P2).

By practising third-degree price discrimination, as seen above, firms can earn more supernormal profit and capture more consumer surplus. This increased profit can be reinvested in the business which can help the firm to become more price and/or non-price competitive as well as improve dynamic efficiency. Third-degree price discrimination may also help firms to deal with differing levels of demand for their goods and services. Consumers in the elastic market will also benefit from lower prices compared to if the firm didn't practice third-degree price discrimination. Moreover, consumers may benefit from improvements in the quality of the goods and services produced by firms that practice third-degree price discrimination. This is because these firms may invest their greater supernormal profits, with these supernormal profits coming about as a result of third-degree price discrimination, and this investment may improve the quality of the goods and services that these firms produce.

A cost to the producer of third-degree price discrimination could include the implementation costs of setting up and managing different price structures which is likely to involve administrative and monitoring costs to prevent arbitrage. The producer may also face backlash from the public as a result of third-degree price discrimination being practised. This is because third-degree price discrimination may be viewed as unfair. A cost to consumers could be that consumers in the inelastic market are likely to pay higher prices than they would in the combined market. Moreover, consumers in the inelastic market may suffer from a fall in consumer surplus.

What are the benefits of monopolies to producers?

• Greater supernormal profits. Monopolies have the ability to set their prices due to high barriers to entry and imperfect knowledge of how much supernormal profit the firm is making. 
• Large economies of scale. These allow the monopoly to produce at a low LRAC and maximise profit. 

What are the costs of monopolies to producers?

• Regulatory scrutiny. The CMA (Competition and Markets Authority) can set harsh regulations that monopolies must follow, and monopolies can get harshly fined and punished if their actions are deemed anti-competitive.
• Efficiency concerns. Monopolies are likely to let costs go out of control, leading to large levels of X-inefficiency which leads to a loss of supernormal profit. 
• Poor public perception. Higher prices and low-quality goods provided by monopolies can lead to consumer dissatisfaction and public backlash.

What are the benefits of monopolies to consumers?

• Potential for high-quality goods. If the monopoly invests its large supernormal profits in R&D (Research & Development), then the consumer may benefit from more innovative and better quality goods and services.
• Stable service. Monopolies are likely to offer stable and consistent service.

What are the costs of monopolies to consumers?

• High prices. Monopolies are likely to set higher prices than those charged in competitive markets, reducing consumer surplus. 
• Limited choice. The consumer can only buy from one firm, so they can't go to another firm to buy the good or service.
• Less innovative products. Due to less competition and high barriers to entry, monopolies are unlikely to conduct as much R&D (Research & Development).

What are the benefits of monopolies to workers?

• Job stability. As monopolies are stable, workers don't have to worry about sudden market fluctuations or closures as much compared to working for a firm in a competitive industry.

What are the costs of monopolies to workers?

• Limited mobility. This is because the monopoly is the only firm in the industry, so the worker can't move to another firm in the same industry.
• Low wages. Monopolies can exploit workers due to their monopsony power and may underpay them.

What are the benefits of monopolies to suppliers?

• Stable demand. As monopolies are typically stable, monopolies often purchase consistently from a supplier, so the supplier can benefit from consistent revenue from the monopoly.
• Long-term contracts. As a monopoly is stable, they can offer long-term contracts to the supplier which they may not receive from more volatile firms in more competitive markets.

What are the costs of monopolies to suppliers?

• Over-dependency. If a supplier is over-reliant on a monopoly for business, it can render the supplier vulnerable to changes in the monopoly's demand for their goods and services.
• Pressure on prices. Monopolies have lots of bargaining power and may try to force the price of a supplier's goods and services down.

What is a natural monopoly?

A natural monopoly exists when it is most efficient to have only one firm in the industry. This is because the natural monopoly will have high fixed costs, rendering it impractical for multiple firms to compete in the market. 

For a natural monopoly, LRAC and LRMC will continue to fall as output increases due to economies of scale. The profit maximising point is where MC=MR at quantity Q and price P. The natural monopoly in this example will make a supernormal profit of the yellow-shaded area. However, as natural monopolies are uncontestable, they must be regulated so that they don't exploit consumers and that they run efficiently. For example, in the diagram, a regulator would note that the natural monopoly is charging a high price of P and making a large amount of supernormal profit. Hence, the regulator would intervene and ensure that the new price is at the point of allocative efficiency at P1 where P=LRMC at quantity Q1. However, the natural monopoly would make a subnormal profit of the blue-shaded area. It would be likely that the natural monopoly producing at this output would be given a subsidy in order to continue operations. 

Examples of areas where natural monopolies operate could include the railway network, the sewer network or the water industry.

What are the characteristics and conditions required for a monopsony to operate?

A monopsony is where there is only one dominant buyer of a particular good or service. They must have a large influence over what price they pay for goods and services due to their dominant position. There must be large barriers to entry for other buyers looking to compete with the monopsonist's dominance.

An example of a monopsony in a market is a monopsony as part of a bilateral monopoly in the labour market.

In a bilateral monopoly, there is one monopoly (in the labour market this is the supplier of labour, i.e. a very strong trade union) and one monopsony (in the labour market this is the buyer of labour). 

Within a bilateral monopoly in the labour market, the monopoly (the trade union) will attempt to bargain for better outcomes for the workers who are employed by the monopsony.

MRP (Marginal Revenue Product) is the extra value of an additional worker (or factor of production) to the firm. The profit-maximising monopsonist will employ workers at quantity Q and wage rate W. However, this is significantly below the value of the worker to the firm at this output, as MRP = W1. Hence, the trade union will attempt to negotiate wages up to W1. The trade union could also try and increase employment to Q1 where AC=MRP, although the wage rate (W2) will be lower than W1. 

What are the costs and benefits for a firm which is a monopsony?

A monopsony will have lower input costs as the monopsony has significant bargaining power with suppliers, so can drive down costs. The monopsony is hence also likely to have larger supernormal profits due to these lower costs. However, a monopsony is likely to be under heavy regulatory scrutiny, for example, from the CMA (Competition and Markets Authority) in the UK. 

What are the costs and benefits for consumers of monopsonies?

A consumer may benefit from lower prices as the monopsonist's input costs are likely to be low. However, the monopsonist may not necessarily pass on these lower costs and may charge higher prices to maximise profit. 

What are the costs and benefits for workers of monopsonies?

Workers may benefit from improved job stability as the firm they work for may be the dominant employer in an industry. However, workers of monopsonies are likely to have low wages as monopsonies can use their dominance to force wages down.

What are the costs and benefits for suppliers of monopsonies?

Suppliers may benefit from consistent demand from monopsonistic firms and long-term contracts. However, the monopsonist is likely to try and exert pressure on them to lower their prices.

What is a contestable market?

A contestable market is where entry and exit into and out of a market is relatively easy, resulting in a significant risk of new businesses entering the market.

What are the characteristics of contestable markets?

1. Low barriers to entry and exit. It should be easy for firms to join and leave the market.
2. No sustainable supernormal profits. Due to the threat of entry from other firms, firms should not be able to sustain supernormal profits in the long run.
3. Efficiency. The threat of competition should incentivise firms in a contestable market to be efficient.

What are the implications of contestable markets upon firms?

In a contestable market, firms will enter the market if supernormal profits are being made by other firms within the market. This will lead to normal profits in the long run, meaning that supernormal profits in a contestable market will likely only be temporary. This also means that firms must be able to be responsive to price changes due to new entrants. They must be able to easily lower prices to match rivals and retain market share.

Firms are likely to be both allocatively and productively efficient. Firms will be allocatively efficient because to retain market share, firms must set prices close to marginal cost, hence achieving allocative efficiency. Firms will be productively efficient as firms will have to minimise costs to reduce prices as much as possible.

What are the different types of barriers to entry/exit?

Some barriers to entry could include: 

• Capital requirements. Some industries require high amounts of initial capital investment to enter the market. 
• Economies of scale. Incumbent firms are likely to be producing at a much larger scale than a new entrant into the market would be, meaning it is difficult for new entrants to compete on price as their LRAC is much higher.
• Brand loyalty. Established firms are likely to have brand loyalty schemes or simply strong customer loyalty, meaning that it would be very difficult for a new entrant to sell to these consumers.
• Legal barriers. Patents or intellectual property rights might render it difficult or impossible for a new entrant to enter the market.

Some barriers to exit could include:

• Exit costs. Firms may have to pay expensive fees to terminate contracts, and selling assets may be quite costly.
• Government regulation. Legal constraints may make it hard for a firm to quickly leave a market.
• Specialised assets. Some assets which the firm has bought may have little to no other uses, so the firm may struggle to recoup the value of these assets.

What are sunk costs?

Sunk costs are the expenses that have already been incurred by a firm that can't be recovered. A good example is advertising as once a firm spends money on advertising that expense can't be recovered, irrespective of whether the campaign succeeded.

What is meant by the degree of contestability?

The degree of contestability is how easy or difficult it is for a firm to enter or exit an industry. Within a highly contestable industry, it is very easy to enter and leave the industry, whereas in an industry with low contestability, it is difficult to enter and leave the industry.