Concentrated markets

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  • Created by: Ellie
  • Created on: 02-04-15 10:58
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  • Concentrated Markets
    • Monopoly
      • Sources to Monopoly Power
        • Barriers to entry : e.g. huge amounts of capital is required to achieve the minimum efficient scale
        • Patent laws: these allow the designer of the product the sole right to exploit the product for a number of years
        • Copy right laws: The same as patent laws but apply to music, publications and intellectual property
        • Nationalised industries: Sometimes competition is prohibited by the state by law
        • Incumbent firms : may have exploited all of the economies of scale and can produce at a lower cost than any entrant coulf. The existing firm could reduce its prices and threaten potential entrants with a price war that would bankrupt possible competitors.
        • The incumbent may create fixed costs: this will make it very expensive to compete. This is especially true if these costs are sunk costs ( those that are irrecoverable if a firm leaves the industry)
        • In some industries a firm may have control over an essential raw material
      • Rules of a monopoly
        • A pure monopoly exists when there is only one firm in the market. The firm is the market and there are barriers to entry
        • The demand curve effects the monopolist by: If the monopolist is a price maker the demand curve dictates the maximum output that can be sold at this price.        If the monopolist is a quantity setter the demand curve dictates the maximum price at which the chosen quantity can be sold.
        • The monopolist faces a trade off between setting output or the price.
        • Marginal revenue does not equal the average revenue in monopoly so when the marginal revenue < average revenue the MR curve is twice as steep as the AR curve
        • Price elasticity of demand falls moving down a linear demand or AR curve facing a monopolist
      • Monopoly profit
        • Monopoly profit is the supernormal profit a monopoly or imperfectly competitive firm makes.
        • It makes supernormal profit as monopolists are able to set the price for their goods and services.
    • Oligopoly
      • The theory of oligopoly
        • Oligopoly describes a market in which a few large firms have the majority of the market share
        • There is no simple set of rules for an oligopolistic equilibrium
        • The way the oligopolistic firm operates is dependant upon the particular set of market circumstances which it faces
        • There are a number of theories which try to explain how the oligopolistic firm will work
        • Although oligopolistic markets are dominated by large firms there are often smaller firms operating in the same market
      • Concentration Ratio
        • A concentration ratio measures the market share of the biggest firms in the market
        • a:b where a= the number of firms and b= the percentage of the firms in the market e.g. 5:75 means 5 firms hold 75% of the market share
        • They express the degree of market concentration so 5:60 is more concentrated than 5:40
        • Other firms in the industry are affected by the dominant firms by: lack of brand loyalty, high entry barriers, other firms can't compete due to bulk buying, other firms need to find a USP
      • Barriers to entry
        • Oligopolistic firms want to ensure that potential competitors stay out of the industry.
        • Advertising: large firms can reduce the unit costs of advertising by spreading fixed costs. New firms can;t match these expenses due to low output
        • Multiplicity of brands: Some firms run a large number of brands allowing consumers to switch between brands with out losing customers
        • None price competition: having offers and sales persuades consumers to use their product without lowering the price and starting a price war
          • Price wars exist when firms competitively lower prices to increase their market share.
        • Brand image: large firms can say their brand is unique to make demand more price inelastic
        • R&D : large firms have a large amount of R&D so they're able to invent products giving them a competitive edge
        • Patents: thee can be acquired for products more easily by large firms.
        • Artificial barriers to entry
          • Limit pricing: the firm which has the lowest costs set their prices at a level where other firms can't compete
          • These barriers to entry are illegal but it's hard to get caught and so are common
          • Predatory pricing: when the firm sets a price that may bankrupt a competitor firm in order to take it over
      • Competitive Oligopoly
        • The firms in an oligopolistic market are interdependent so the actions of the firm effects the other firms
        • The ways that firms compete are: If one firm raises its prices another firm might not change theirs to gain more market share and if one firm lowers its price others might lower their prices further
      • Collusive Oligopoly
        • Collusion is where firms cooperate in their pricing and output decisions
        • A cartel is a collusive agreement to fix prices
        • The rules of collusion
          • All major producers in the cartel must follow its rules
          • The market being supplied should be isolated from supply by the producers not in the cartel
          • There are high barriers to entry
          • The more homogeneous the product the greater the chance of success
          • Firms make more profits as group but one firm might make more profit for itself if it leaves the cartel
        • Outcomes of a cartel
          • For Producers
            • An increase in sales revenue and profit
            • Increased likelihood that producers will compete by non price competition
            • It can lead to increased investment due to more profits
            • Investigation by the office of fair trading
          • For Consumers
            • An increase in the price of a product
            • Increased production costs for firms buying the goods
            • Reduction in consumer surplus
            • It can lead to consumer benefits like loyalty cards and sales
        • A cartel reduces the uncertainty an oligopolist faces. Cartels are illegal as they are bad for consumers. Joint product development and coorporation to improve health and safety are examples of where cartels are good
      • Game Theory
        • This is a mathematical approach to the study of conflict and decision making treating conflict as games with tactics and strategies
        • Nash equilibrium is the equilibrium where each players strategy is optimum given the strategy of the other
        • The dominant strategy is not the best outcome for them both but it would be the best outcome for an individual
      • Pricing in oligopolistic markets
        • Cost plus pricing
          • This is the most common method where firms set their selling price by adding a standard % profit margin onto average unit costs
          • If customers are willing to pay mark up can be higher. In competitive firms mark up is limited
        • Price parallism
          • When there are identical prices and price movements with in a market
          • It can occur in highly competitive markets and oligopolistic markets when collusion is around
        • Price leadership
          • One firm becomes the market leader and the other firms in the industry follow its pricing example
        • marginal cost pricing
          • This is used when demand varies on a daily weekly or seasonal basis
        • Cross subsidy
          • All customers pay the same price but the marginal cost of supplying the good varies between different customers this maximises consumer good will.
          • It results in allocative inefficiency  e.g. its the same price for 1st class letters regardless of destination
        • Limit pricing and predatory pricing
        • Price discrimination
    • The Growth of firms
      • Internal growth
        • This occurs when a firm invests in a new capacity from scratch (a new factory of office)  its also called organic growth
      • External growth
        • This is growth via takeover or merging and acquisition of another firm
      • Vertical Growth
        • This is when a firm grows by expanding back up its supply chain or forward a long its distribution chain
        • Backward vertical growth
          • This occurs when a firm decides to produce its own equipment e.g. if a car firm decides to produce its own parts
        • Forward vertical growth
          • This occurs if the company owns the distribution chain in which the company sells its product e.g if a car firm owned a show room
        • This allows a firm to have greater control over its production or distribution process it also gives the firm better access to raw materials and better control of distribution.
      • Horizontal growth
        • This occurs when a firm undertakes more of the activities its already involved in which can lead to economies of scale
        • E.g. if a firm built more plants at the same stage of production in the same industry.
        • A firms incentives for horizontal growth are : increased economies of scale, eliminate competitors, increase monopoly power
      • Lateral growth
        • This occurs when a firm diversifies into new types of production it can also be called conglomeration
        • E.g. if a car company took over a sat nav firm
        • It enables firms to diversify and gain scale economies of mass resources and risk spreading. The companies that join would have related products.
        • It may cause managerial and organisational dis-economies of scale due to a lack of expertise in the field the firm is expanding into.
      • Firms grow when demand fro the foods and services the firm is producing increases so the firm increases its output, productive capacity and or scale to keep up .
      • Growth increases consumer surplus but it can decrease profits
    • Price discrimination
      • First  Degree
        • This is where consumers are charge the maximum price they're willing to pay meaning there is no consumer surplus
      • Second Degree
        • This is where prices are charged depending on the quantity consumed
      • Third Degree
        • This is where different groups of people are charged different prices
      • Conditions
        • Differences in PED; the firm can charge a higher price to the group with a more inelastic demand meaning firms can increase total revenue and profits
        • Barriers to prevent consumers switching suppliers: where consumers who purchase a product are able to resell it at a higher price. This can be solved by selling a unique product or offering reductions for certain users
      • Advantages
        • Firms can increase revenue enabling them to stay in business
        • Increased revenue can be used for R&D which benefits consumers
        • Some consumers benefit from lower prices
      • Disadvantages
        • Some consumers end up paying higher prices
        • There is a decline in consumer surplus and those who pay higher prices may not be the wealthiest
        • There might be administration costs to separate the market
        • Profits from price discrimination could be used to finance predatory pricing
      • This is when different customers are charged different prices based on their willingness to pay.
      • Examples are: Student discount, advanced buying discount, discount for off peak, lower costs for buying igh quantitiy
    • Consumer and producer surplus
      • Consumer Surplus
        • This is a measure of the eonomic welfare enjoyed by consumers and is the surplus utility recieved over and above the price paid for the good. It is shown by the top triangle on a demand and supply curve.
        • When there is  a decrease in price consumer surplus will increase and producer surplus will decrease
      • Producer Surplus
        • This is a measure of economic welfare enjoyed by the producers and is the difference between the price a firm is charging and the price the firm would like to charge
        • When there is an increase in price consumer surplus will decrease and producer surplus will increase
        • In a monopoly there is a large amount of producer surplus
      • Economic welfare is a measure of human happiness or satisfaction it can be split into the happiness of consumers and producers.
    • Contestable and Non Contestable markets
      • Assumptions
        • Low barriers to entry
        • No single firm has significant share of the market place
        • Firms compete so collusion doesn't occur
        • Firms are short run profit maximisers
        • Firms may produce homogeneous or heterogeneous goods
        • There is perfect knowledge in the market
      • Definition
        • A contestable market is one where there is free entry and exit for incumbent and new firms
          • Free entry assumes that all firms have acsess to the same technology and have the same cost curves
          • Free exit assumes there are no sunk costs when a firm leaves the industry
        • Contestable market theory states that any form of entry  into the market is very costly - these costs are sunk costs
        • A market is contestable even if the firm pays some costs of entry as long as they are recovered when it leaves the market
        • The lower the sunk cost of entry the more contestable the market
        • If the market is contestable the incumbent firms will fear new entrants and reduce their price so they produce at normal profit levels
        • If the market is contestable benefits of perfect competition might be achieved with out all the ocnditions being met.
          • Oligopoly and Monopoly firms could be made contestable and act like perfect competition so: They will only earn normal profits, if lossers are made firms must leave the industry
        • As long as there is a threat of competition consumers can be protected from abusers of monopoly and oligopoly power
      • Benefits
        • Reduces the likelihood of government failure as governments shouldn't have to intervene with the market
        • It can suggest a more analytical approach when trying to predict a firms pricing and output behaviour
      • Criticisms
        • Limited application as sunk costs may be extremely high and mergers and take overs create unachievable economies of scale
        • Level of technological knowledge and expertise to enter a market can be high
        • Patents can protect incumbent firms
        • The theory ignores aggressive behaviour from incumbents like limit pricing
      • In reality
        • There are many industries where it is difficult to recover sunk costs
        • New firms may have a temporary disadvantage as they don't have the same industry knowledge as incumbent firms
        • Barriers to entry can be difficult to move

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