2.11 Market failure—market power (HL only)

Perfect competition–many firms, free entry, homogeneous products

Monopoly—single or dominant firm, high barriers to entry, no close substitutes

Imperfect competition

• Oligopoly—few large firms, high barriers to entry, interdependence

• Monopolistic competition—many firms, free entry, product differentiation

Rational producer behaviour—profit maximization (HL only)

• Total revenue - Total costs (TR -TC)

• Marginal cost = Marginal revenue (MC=MR)

• Abnormal profit (AR > AC)*

• Normal profit (AR = AC)*

• Losses (AR < AC)*

* AR = Average revenue, AC = Average cost

Calculation (HL only): profit, MC, MR, AC, AR from data

Diagrams for Revenue and Cost:

1. Total Product

2. Average/Marginal Product

3. Total Costs (TC, AVC, ATC)

4. Average/Marginal Cost

5. Long Run Average Total Cost

6. Average/Marginal/Total Revenue (for Price Taker)

7. Average/Marginal/Total Revenue (for Price Maker)

8. Normal Profit

9. Economic Profit

10. Economic Loss

Costs of production: economic costs:

- Explain the meaning of economic costs as the opportunity cost of all resources employed by the firm (including entrepreneurship).

- Distinguish between explicit costs and implicit costs as the two components of economic costs.

Costs of production in the short run:

- Explain the distinction between the short run and the long run, with reference to to fixed factors and variable factors.

- Distinguish between total costs, marginal costs and average costs.

- Draw diagrams illustrating the relationship between marginal costs and average costs, and explain the connection with production in the short run.

- Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable costs, average total costs and marginal costs from a set of data and/or diagrams.

Total Costs, Average Costs, Variable Costs Marginal costs:

Why do the MC and ATC curves look the way they do? 

Short-run profit maximization rule sylabus requirements:

• Describe economic profit as the case where total revenue exceeds the economic cost. 

• Describe normal profit as the amount of revenue needed to cover the costs of employing self-owned resources (implicit costs, including entrepreneurship)or the amount of revenue needed to just keep the firm in business. 

• Explain that economic profit is profit over and above normal profit and that the firm earns a normal profit when economic profit is zero.

• Explain why a firm will continue to operate even when it earns zero economic profit.

• Explain the meaning of a loss as negative economic profit arising when total revenue is less than total cost. 

• Calculate different profit levels from a set of data and/or diagrams. 

• Explain the goal of profit maximization where the difference between total revenue and total cost is maximized or where marginal revenue equals marginal cost. 

Market Structures

Syllabus Requirements:

• Describe, using examples, the assumed characteristics of perfect competition: a large number of firms; a homogenous product; freedom of entry and exit into the market; perfect information; perfect resource mobility.

• Cost and revenue curves in a PC market: 

• Explain, using a diagram, the shape of the perfectly competitive firms average revenue and marginal revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price taker. 

• Explain, using a diagram, that the perfectly competitive firm's average revenue and marginal revenue curves are derived from market equilibrium for the industry. 

• Profit maximization in the short run:

• Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit (supernormal profit), normal profit or negative economic profit in the short run based on the marginal cost and marginal revenue profit maximization rule. 

• Profit maximization in the long run:

• Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit.

• Explain, using a diagram, how a perfectly competitive market will move from short-run equilibrium to long-run equilibrium.

• Efficiency in the perfectly competitive market:

• Explain the meaning of the term allocative efficiency

• Explain that the condition for allocative efficiency is P=MC (or with externalities, MSB=MSC).

• Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the short run and the long run. 

• Explain the meaning of the term productive/technical efficiency.

• Explain that the condition for productive efficiency is that production takes place at minimum average total cost. 

• Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run. 

Monopoly Syllabus Requirements:

• Assumptions of the model

• Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in the market; no close substitutes; significant barriers to entry. 

• Barriers to entry

• Describe, using examples, barriers to entry, including economies of scale, branding and legal barriers. 

• Demand and revenue curves under monopoly

• Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward sloping. 

• Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly. 

• Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve.

• Profit maximization for the monopolist

• Explain, using a diagram, the short and long-run equilibrium output and pricing decision of a profit-maximizing (loss minimizing) monopolist, identifying the firm's economic profit (or losses).

• Explain the role of barriers to entry in permitting the firm to earn economic profit.

• Revenue maximization 

• Explain, using a diagram, the output and pricing decision of a revenue-maximizing monopoly firm. 

• Compare and contrast, using a diagram, the equilibrium positions of a profit-maximizing monopoly firm and a revenue-maximizing monopoly firm. 

• Calculate from a set of data and/or diagrams the revenue-maximizing level of output.  

• Natural monopoly

• With reference to economies of scale, and using examples, explain the meaning of the term 'natural monopoly'.

• Draw a diagram illustrating a natural monopoly.

• Disadvantages and advantages of monopoly

• Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development and economies of scale. 

• Explain why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development from economic profits, the need to innovate to maintain economic profit, and the possibility of economies of scale. 

• Monopolies and efficiency

• Explain, using diagrams, why the profit-maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. 

• Policies to regulate monopoly power

• Evaluate the role of legislation and regulation in reducing monopoly power. 

• Price discrimination 

• Describe price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost. 

• Explain that pice discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticities of demand for the product; the firms must be able to separate groups to ensure that no resale of the product occurs.  

• Draw a diagram to illustrate how a firm maximizes profit in third-degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. 

Monopolistic Competition and Oligopoly syllabus requirements: 

• Assumptions of the model

• Describe, using examples, the assumed characteristics of a monopolistic competition: a large number of firms; differentiated products; absence of barriers to entry and exit. 

• Demand and revenue curves for monopolistic competition

• Explain that product differentiation leads to a small degree of monopoly power and therefore to a negatively sloping demand curve for the product. 

• Profit maximization in monopolistic competition

• Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit-maximizing (loss minimizing) firm in monopolistic competition, identifying the firm's economic profit (or loss).

• Explain, using diagrams, why in the long run a firm in monopolistic competition will make normal profit. 

• Price and non-price competition

• Distinguish between price competition and non-price competition. 

• Describe examples of non-price competition, including advertising, packaging, product development and quality of service. 

• Monopolistic competition and efficiency

• Explain, using a diagram, why neither allocative efficiency nor productive efficiency are achieved by monopolistically competitive firms. 

• Monopolistic competition vs perfect competition and monopoly

• Compare and contrast, using diagrams, monopolistic competition with perfect competition, and monopolistic competition with monopoly, with reference to factors including short run, long run, market power, allocative and productive efficiency, number of producers, economies of scale, ease of entry and exit, size of firms and product differentiation. 

• Oligopoly

• Describe, using examples, the assumed characteristics of an oligopoly: the dominance of the industry by a small number of firms; the importance of interdependence; differentiated or homogenous products; high barriers to entry.

• Explain why interdependence is responsible for the dilemma faced by oligopolistic firms - whether to compete or collude. 

• Explain how a concentration ratio may be used to identify an oligopoly.

• Game Theory

• Explain how game theory (the simple prisoner's dilemma) can illustrate strategic interdependence and the options available to oligopolies.

• Collusive oligopoly

• Explain the term 'collusion', give examples, and state that it is usually (in most countries) illegal. 

• Explain the term 'cartel'.

• Explain that the primary goal of a cartel is to limit competition between member firms and to maximize joint profits as if the firm were collectively a monopoly.

• Explain the incentive of cartel members to cheat.

• Analyse the conditions that make cartel structures difficult to maintain. 

• Tacit or informal collusion

• Describe the term 'tacit collusion', including reference to price leadership by a dominant firm. 

• Non-collusive oligopoly

• Explain that the behaviour of firms in a non-collusive oligopoly is stretegic in order to take account of possible actions by rivals. 

• Explain, using a diagram, the existence of price rigidities, with reference to the kinked demand curve. 

• Explain why non-price competition is common in oligopolistic markets, with reference to the risk of price wars. 

• Describe using examples, types of non-price competition. 

• Real World Economics:

Syllabus Reqs:

Degrees of market power

• Meaning of market power

• Perfect competition—no market power—firm as price taker

  • profit maximization: in the short run, in the long run

  • Meaning of allocative efficiency, necessary conditions

  • Imperfect competition—varying degrees of market power—firm as price maker

Diagram: perfectly competitive firm as price taker where,

*P = D = AR = MR

Diagram: perfectly competitive firm showing:

• abnormal profit

• normal profit

• losses

Diagram: equilibrium in perfectly competitive market with reference to allocative efficiency when P = MC or MB = MC, maximum social/community surplus.

*P = Price, D = Demand

Monopoly

• Profit maximization

• Allocative inefficiency (market failure)

• Welfare loss in a monopoly in comparison with perfect competition due to restricted output and higher price

• Natural monopoly

Diagram: market power where AR > MC

Diagram: monopolist showing:

• abnormal profit

• normal profit

• losses

Diagram: price/quantity comparison of a monopoly firm with a perfect competitive market. Also showing welfare loss under the monopoly.

Diagram: natural monopoly

Oligopoly

• Collusive versus non-collusive

• Interdependence, risk of price war, incentive to collude, incentive to cheat

• Allocative inefficiency (market failure)
  simple game theory payoff matrix

• Price and non-price competition

• Measurement of market concentration – concentration ratios

Diagram: collusive oligopoly acting as a monopoly

Monopolistic competition

• Profit maximization:

  • in the short run

  • in the long run

• Less market power due to many substitutes—more elastic demand curve compared with monopoly

• Allocative inefficiency (market failure)

• Less inefficiency, more product variety

Diagram: monopolistically competitive firm showing:

• abnormal profit

• normal profit

• losses

Diagram: monopolistic competition (with a more elastic demand curve compared to a monopoly)

Advantages of large firms having significant market power, including:

• Economies of scale including natural monopolies

• Abnormal profits may finance investments in research and development (R&D), hence innovation

Risks in markets dominated by one or a few very large firms

• Risks in terms of output, price, consumer choice

Government intervention in response to abuse of significant market power

• Legislation and regulation

• Government ownership

• Fines