2.11 Market Failure: Market Power (DP IB Economics: HL): Flashcards

For a perfectly competitive firm the selling price is the same as the market price, so P = MR = AR = Demand.

A perfectly competitive firm is unlikely to achieve dynamic efficiency because it is unlikely to earn the abnormal profits needed to reinvest in innovation.

Explicit costs are the costs of production that have to be paid, such as raw materials and wages.

Implicit costs are the opportunity costs of production, representing the value of the next best alternative use of the firm's resources.

Profit = total revenue (TR) − total costs (TC), where total costs include both explicit and implicit costs.

Normal profit occurs when total revenue equals total costs (TR = TC), which is also known as breakeven.

False.

Abnormal profit occurs when total revenue exceeds total costs (TR > TC); a firm makes a loss when TR < TC.

Profit maximisation is the rational business objective of producing at the level of output where the difference between total revenue and total costs is greatest.

A firm maximises profit at the output where marginal cost equals marginal revenue (MC = MR), as no additional profit can be extracted by producing another unit.

While marginal cost is below marginal revenue, a firm can still increase its total profit by producing an extra unit of output.

Beyond the point where MC = MR the firm has passed its profit-maximising output and makes a marginal loss on each additional unit, because MC > MR.

Average cost = total cost ÷ number of units, giving the cost per unit of output.

A firm is allocatively efficient when its price (AR) is equal to its marginal cost (MC).

A firm is productively efficient when its average total cost equals its marginal cost (ATC = MC).

A firm in perfect competition has low market power, along with a low market share and a low industry concentration ratio.

A price taker is a firm that has no market power and must accept the market price, so its selling price equals the market price where P = MR = AR = Demand.

False.

In the short run perfectly competitive firms can make abnormal profit or losses; only in the long run do they always return to normal profit.

For a firm in perfect competition, the marginal cost (MC) curve is also its supply curve.

A perfectly competitive firm makes abnormal profit in the short run when average revenue exceeds average cost (AR > AC) at the profit-maximising output.

Because there are no barriers to entry, new firms attracted by abnormal profit join the industry, shifting supply right and lowering price until only normal profit remains.

In the long run, firms in perfect competition always make normal profit.

A perfectly competitive firm is making a short-run loss when average revenue is below average cost (AR < AC) at the profit-maximising output.

False.

Loss-making firms leave the industry, so supply shifts to the left, raising the price until remaining firms return to normal profit.

Some firms leave the industry (there are no barriers to exit), so supply falls and the price rises until the remaining firms make normal profit again.

Allocative efficiency occurs at the output where average revenue equals marginal cost (AR = MC), so resources are allocated to give consumers and producers the maximum possible benefit.

Productive efficiency occurs at the output where marginal cost equals average cost (MC = AC), so average costs are minimised and scarce resources are not wasted.

A monopoly is a market structure with a single seller and no substitute products, giving the firm complete market power to set prices and control output.

A monopoly has absolute market power, with a high or total market share and a high industry concentration ratio.

Governments regulate mergers and acquisitions to prevent the abuse of market power, often ensuring that no single firm gains more than 25% market share.

False.

A monopoly's abnormal profits are not eroded in the long run because high barriers to entry prevent competitors from entering the industry.

A price maker is a firm with market power that can set its own price, which is why its revenue curves are downward sloping.

A monopoly makes abnormal profit when average revenue exceeds average cost (AR > AC) at the profit-maximising output where MC = MR.

A monopoly makes normal profit when average revenue equals average total cost (AR = ATC), so it breaks even and just covers its opportunity costs.

A monopoly minimising losses in the short run has a price (AR) below average total cost but above its marginal cost (MC).

True.

Competition drives perfectly competitive firms to both efficiencies, while a monopoly is usually inefficient in both, creating a welfare loss.

A monopoly is allocatively inefficient because price exceeds marginal cost (P > MC), so the price is above the opportunity cost of production and resources are misallocated.

Abnormal profits can fund product innovation and better-quality products, and economies of scale may lower average costs that are passed on as lower prices.

False.

Because there is no competition, a monopoly has a reduced incentive to be efficient, and innovation and customer service may suffer.

A natural monopoly occurs when the most efficient number of firms in the industry is one, typically because of high infrastructure and sunk costs and significant economies of scale.

Governments usually regulate a natural monopoly by imposing a maximum price, ensuring consumers are not charged higher monopoly prices.

An oligopoly is a market structure in which a few large firms dominate the industry, each holding significant market power and a large market share.

An oligopoly is characterised by a few dominant firms, high barriers to entry and exit, a high concentration ratio, interdependence between firms, and product differentiation.

A concentration ratio measures the percentage of total market share held by a specific number of the largest firms in an industry.

A five-firm concentration ratio of around 60% is generally considered to indicate an oligopoly.

Collusion occurs when firms cooperate rather than compete, typically to fix prices and restrict output so they can raise profits.

False.

There is little incentive to compete on price, because rivals quickly match cuts, leaving market shares unchanged but reducing profits; the incentive is to collude.

Overt collusion involves firms explicitly agreeing to fix prices, whereas tacit collusion avoids formal agreements and instead relies on closely monitoring each other's behaviour.

A cartel is the most restrictive form of collusion, where firms explicitly agree to fix prices or limit competition, and it is illegal in most countries.

Price leadership is the most common form of tacit collusion, where firms monitor and match the price set by the largest firm in the industry.

Game theory is a mathematical framework used to make optimal decisions in strategic situations where there is a high level of interdependence, such as in oligopoly markets.

Any game has three elements: the players, the strategies available to them, and the payoffs each player receives for each combination of strategies.

The dominant strategy is the option each firm ends up choosing because it carries the least risk, even though colluding would give both a better outcome.

Predatory pricing is lowering prices, often below the cost of production, to drive a new competitor out of the market, after which prices are raised again; it is usually illegal as it is anticompetitive.

Limit pricing is when firms set a price low enough to reduce potential profits and discourage other firms from entering the industry.

The aim of non-price competition is to increase product differentiation, build brand loyalty and increase market share.

Monopolistic competition is a market structure with a large number of small firms offering a similar product but with some product differentiation, and low barriers to entry and exit.

Product differentiation is making a product appear slightly different from those of competitors, for example two nail bars offering express or pampered service.

Normal profit occurs when total revenue equals total cost (breakeven), and it is the long-run equilibrium outcome for firms in monopolistic competition.

Firms in monopolistic competition have some but low market power, a low industry concentration ratio and a market share only slightly higher than in perfect competition.

The demand curve is relatively elastic (shallow) because there are a large number of substitute products available to consumers.

Because the firm must lower its price to sell an extra unit, the MR curve falls twice as quickly as the AR curve.

It makes abnormal profit when average revenue exceeds average cost (AR > AC) at the profit-maximising output where MC = MR.

It makes a short-run loss when average revenue is below average total cost (AR < ATC) at the profit-maximising output.

It is not productively efficient because average cost exceeds marginal cost (AC > MC) at the profit-maximising level of output.

In monopolistic competition there are low barriers to entry and exit, so firms can join or leave the industry with relative ease.

False.

In the short run they can make abnormal profit or losses; only in the long run do new entrants or exits return them to normal profit.

True.

The more competitive environment pushes firms towards higher efficiency and offers consumers more products, even when abnormal profits are earned in the short run.

Legislation involves the creation of new laws by government.

Regulation involves enforcing the laws, usually assisted by the creation of regulatory agencies such as the European Competition Commission.

Nationalisation occurs when the government takes control and ownership of firms that were previously in the private sector.

Market power can bring higher abnormal profits and easier access to finance, along with funds for research and development, economies of scale, strong branding and greater strategic freedom.

By reducing competition, market power can lead to higher prices, reduced consumer choice and decreased efficiency in the market.

It monitors merger activity to prevent any single firm gaining more than 25% market share, and has the authority to block a merger of concern.

The Competition and Markets Authority (CMA) is the UK government regulator responsible for ensuring monopoly power is avoided.

Governments can pass anti-monopsony laws, issue fines for breaches, and set minimum prices that buyers must pay their suppliers.

A government may nationalise industries that are strategically important, to ensure the provision of essential services, or to address market failures and redistribute wealth.

In Europe, firms can be fined 10% of their sales revenue for breaching anti-competitive practices.

Overregulation can stifle competition and deter investment, while insufficient regulation can lead to market dominance.

False.

Government-owned firms can run very inefficiently, carry an opportunity cost, and the government may lack the expertise to run the business.

False.

The fine is often less than the profit generated by the anti-competitive behaviour, and firms may fund legal action and settle out of court for reduced amounts.