Unit 2.11 - Market Failure: Market Power

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Cost-saving benefits from the industry's overall growth.

External economies of scale

Earnings that occur when revenue exceeds average total expenses at the output level.

abnormal profit

Lower average costs resulting from a firm's own growth.

Internal economies of scale

Spending aimed at creating new products or innovations.

Research and development

The ability of a firm to influence the price of a product, typically above competitive levels.

market power

The phenomenon where increasing production levels result in a decrease in the average cost per unit.

economies of scale

Productive capacity

The maximum output a firm can produce with its available resources, which can be increased through research and development, improving efficiency and competitiveness.

Research and development (R&D)

Spending aimed at developing new products, processes, or innovations, funded by abnormal profits, which can enhance a firm's competitiveness and provide consumers with better choices.

A market that can sustain only one firm profitably, because a single producer meets total demand at a lower average cost than several could.

natural monopoly

Achieved when production occurs at the lowest average cost, minimizing waste.

Productive efficiency

Market structures characterized by varying levels of power among firms, leading to non-competitive behavior.

imperfect competition

State the formula: P (P)

P = MC Condition for allocative efficiency where price equals marginal cost.

Price (P)

The amount of money consumers are willing to pay for a good or service, which, when equal to marginal cost, indicates allocative efficiency. This balance maximizes social surplus and ensures resources are allocated effectively.

marginal revenue

The additional revenue generated from selling one more unit of a good or service. It is crucial for firms to determine optimal output levels, as they aim to produce where marginal revenue equals marginal cost for maximum profit.

The cost per unit at varying output levels when at least one production factor is fixed.

Short run average cost (SRAC)

The cost per unit when all production factors are variable, reflecting long-term efficiency.

Long run average cost (LRAC)

State the formula: Average fixed cost decreases as output increases

AFC = Fixed Costs / Quantity Average fixed cost decreases as output increases.

State the formula: average revenue (AR)

AR = P average revenue (AR)

State the formula: marginal revenue (MR)

MR = AR marginal revenue (MR)

A measure of market concentration that gives greater weighting to the market share of larger firms by squaring the value of their market share.

Herfindahl Index

A metric that indicates the level of market power by summing the market shares of a few leading firms.

concentration ratio

An economic model explaining strategic interdependence between the few large firms in an oligopoly, where each one's best move depends on what its rivals do.

game theory

The extent to which sales revenue in an industry is dominated by one or more of the largest firms.

market concentration

The strategy of using pricing tactics to compete within an industry.

price competition

Herfindahl–Hirschman Index (HHI)

An index that measures market concentration by summing the squares of the market shares of all firms in an industry, indicating the level of competition and market power within that industry.

Nash equilibrium

A situation in which firms in an oligopoly, acting in their own self-interest, reach a point where their strategies result in a suboptimal outcome for all, as seen in price competition leading to lower payoffs than potential collusion.

Payoff matrix

A tool used in game theory to illustrate the potential outcomes of different strategies chosen by firms in an oligopoly, showing how their decisions affect each other's payoffs.

collusion

An agreement between firms to restrict competition, often resulting in higher prices and reduced output. Collusion can lead to increased profits for firms but is generally illegal due to its anti-competitive nature.

dominant strategy

A strategy that yields the highest payoff for a firm, regardless of what the competitor does. In oligopoly, firms often have incomplete information about rivals, leading to a tendency to choose strategies that may not align with optimal market outcomes, as seen in the prisoner’s dilemma scenario.

loss-leader pricing

A pricing strategy where a product is sold below its cost to attract customers, with the expectation that they will purchase additional products with higher profit margins. This tactic is often used by oligopolists like large supermarkets to increase overall sales.

Monetary penalties imposed by authorities for breaking laws.

fines

The act of a government acquiring privately owned businesses or assets.

nationalization

The classification of firms within an industry based on their pricing power, number, size, and competition levels.

market structure

Contestability

A measure of how easy it is for new firms to enter a market, which can be reduced by anti-competitive practices like limit pricing. High contestability encourages competition and can prevent monopolistic behavior.

Government ownership

The process where the government takes control of privately owned firms or industries, known as nationalization, aims to ensure that these entities serve the public interest rather than focus solely on profit. This can reduce the risk of market power abuse by larger firms.

Legislation and regulation

Government measures designed to control firms with significant market power, including laws that prevent anti-competitive practices and ensure fair treatment of consumers.

Merger prevention

Actions taken by governments to block mergers that could lead to excessive market dominance, aimed at protecting competition and preventing higher prices for consumers.

Promoting competition

Strategies employed by governments to enhance competition in markets, such as removing entry barriers and providing support for new firms, to ensure a more contestable market.

Regulators

Entities that enforce laws and regulations to control firms with significant market power, ensuring they do not engage in anti-competitive practices. Regulators can prevent mergers and penalize firms that treat customers unfairly.

Sale of existing assets (divestiture)

A government strategy requiring a monopolist to sell parts of its business or assets to reduce market power and increase competition when a firm is deemed too large.

average cost pricing

A pricing strategy where a firm sets its prices based on the average cost of production. Governments may enforce this to ensure that monopolists do not exploit their market power, aiming for fair pricing that covers costs.

competition laws

Regulations designed to prevent anti-competitive practices and promote fair competition in the market. These laws can impose fines and penalties on firms that violate them, impacting their costs and market behavior.

marginal cost pricing

A pricing strategy where a firm sets its prices equal to the marginal cost of production. This approach is used by governments to promote allocative efficiency in monopolistic markets, ensuring that prices reflect the cost of producing one additional unit.

mergers

The combination of two firms into one, which can lead to increased market power. Governments may prevent mergers if they believe it will result in undesirable market dominance, as seen in regulations that block certain large mergers.

Conditions that prevent new firms from entering a market freely.

barriers to entry

Entities that must accept the prevailing market rate without any ability to set it.

price takers

Identical goods supplied by firms in a competitive market.

homogeneous products

consumer

An individual or entity that purchases goods or services for personal use. Their behaviour matters because it drives market dynamics and firms' pricing strategies.

entry and exit

The process by which firms can freely enter or exit a market, affecting supply and prices, leading to long-run equilibrium where only normal profits are earned.

equilibrium

A state in the market where supply meets demand, leading to a stable price and quantity. In perfectly competitive markets, this balance ensures that no single firm can influence market conditions, contributing to efficient resource allocation.

A scenario where entering or leaving a sector is unhindered, promoting competition among potential entrants.

contestable market

A situation where production costs per unit increase as a firm's output expands beyond an optimal level.

diseconomies of scale

The overwhelming volume of marketing messages that consumers encounter, often resulting in confusion.

advertising clutter

The point at which all economies of scale have been exploited.

minimum efficient scale

The situation where total revenues are greater than total costs, including all costs.

economic profit

Demand curve (D = AR)

The demand curve in monopolistic competition, where price equals average revenue (D = AR), indicating that firms have some market power due to product differentiation but face elastic demand.

A calculation showing the mean expenditure per unit of output, derived from total spending divided by quantity.

Average costs (AC)

A market structure characterized by a single supplier of a particular good or service.

monopoly

A market structure characterized by a small number of large firms that hold significant market control.

Oligopoly

A market structure characterized by numerous firms, each with a limited ability to influence market prices.

monopolistic competition

A single or dominant firm with enough control over how much reaches the market to set what it charges, instead of accepting the going rate.

price maker

A situation occurs when price equals average total cost.

normal profit

Costs that are directly identifiable and measurable, such as wages and materials.

Explicit costs

Expenses related to a firm's production activities.

Costs

Expenses that change directly with the output level.

Variable costs

Expenses that remain constant regardless of output levels.

Fixed costs

Market situation with only one firm present.

Pure monopoly

Market structure where firms act independently without collusion.

Non-collusive oligopoly

Money received from selling a firm's goods or services.

Revenue

Overall expenses that vary directly with the level of production output.

Total variable costs (TVC)

Per unit measure of unchanging production costs.

Average fixed costs (AFC)

Setting prices below the level to deter new entrants.

Limit pricing strategy

The complete sum of all costs that do not vary with production levels.

Total fixed costs (TFC)

The direct production costs associated with each unit of output.

Average variable costs (AVC)

The opportunity costs associated with a firm's resources, representing forgone income.

Implicit costs

The situation where a firm's total costs exceed its total revenue.

Loss

The tendency of firms in a non-collusive oligopoly to leave what they charge unchanged even when demand or costs move.

price rigidity

The total of all explicit and implicit costs incurred by a firm during production.

Economic costs

The typical amount received per unit sold, calculated from total sales.

average revenue

When average revenue is below average cost, resulting in negative financial performance.

Loss condition

State the formula: AVC

AVC = TVC ÷ Q Average variable cost equals total variable cost divided by output.

State the formula: Average cost equals total cost divided by output

AC = TC ÷ Q Average cost equals total cost divided by output.

State the formula: Average fixed cost equals total fixed cost divided by output

AFC = TFC ÷ Q Average fixed cost equals total fixed cost divided by output.

State the formula: MC (MC)

MC = ΔTC ÷ ΔQ Marginal cost equals the change in total cost divided by the change in output.

State the formula: MR (MR)

MR = ΔTR ÷ ΔQ Marginal revenue equals the change in total revenue divided by the change in output.

State the formula: TR

TR = P × Q Total revenue equals price per unit multiplied by quantity sold.

State the formula: Total cost equals total fixed cost plus total variable cost

TC = TFC + TVC Total cost equals total fixed cost plus total variable cost.

Abnormal profit (supernormal profit, economic profit)

Profit that exceeds normal profit, which is the minimum required to keep a firm operating. Abnormal profit incentivizes firms to increase production and can indicate market power or barriers to entry that limit competition.

Domination of resources

A situation where a monopolist controls all necessary resources, preventing new firms from entering the market, such as land or raw materials.

Limit pricing

A strategy where a monopolist sets prices low enough to deter new entrants from competing, thus maintaining market dominance and reducing contestability.

Loss (negative profit)

A situation where a firm's total costs exceed its total revenue, resulting in negative profit. This occurs when the average revenue is insufficient to cover the average cost of production, making it unsustainable in the long run.

No close substitutes

The absence of similar products in the market allows a monopolist to charge higher prices and maintain demand, as consumers have limited alternatives.

Non-price competition

A strategy used by firms in oligopolistic markets to compete through product differentiation and advertising rather than price changes. This approach helps firms maintain prices while attracting customers through unique offerings or promotional schemes.

Price maker (price setter)

A firm with significant market power that can influence the price of its product, unlike price takers in perfect competition, leading to higher prices for consumers.

Product differentiation

The process of distinguishing a firm's products from competitors through unique features or branding, which allows for price variation and consumer choice.

Technical economies of scale

Cost advantages that firms experience as they increase production, leading to lower average costs. Larger firms can invest in advanced technology and efficient production methods, making it difficult for smaller firms to compete due to higher costs.

anti-competitive practices

Strategies that firms use to suppress competition, such as limit pricing or exclusive contracts. These actions create obstacles for potential competitors, reducing market contestability, and may lead to legal scrutiny or penalties.

dominance of resources

A situation where a few large firms control significant market share, making it difficult for new entrants to compete. This dominance creates high barriers to entry and prevents price reductions in oligopolistic markets, affecting overall competition.

legal barriers

Restrictions based on laws and regulations that inhibit new firms from entering a market. These barriers can include required licenses, patents, or safety regulations that protect existing companies and maintain their market position.

A situation where a dominant firm sets a price that others in the market follow.

Price leadership

An agreement among firms to limit competition and manipulate market price through practices like price fixing.

Collusive oligopoly

An arrangement between firms in the same industry to collude on pricing or output levels.

Cartel

Selling below an agreed price in a collusive market, seen as a breach of agreement.

Undercutting

Allocative inefficiency

A situation where resources are not allocated in a way that maximizes social welfare, often seen in oligopolistic markets. Firms may charge prices above marginal cost, leading to reduced output and higher prices for consumers.

Price fixing

An anti-competitive practice where firms in an oligopoly agree to set prices at a certain level to maximize profits, often leading to higher prices for consumers and reduced competition in the market.

Price war

A competitive situation where firms continuously lower prices to gain market share, often leading to reduced profits for all involved. Price wars can be detrimental to firms, despite providing short-term benefits to consumers.

Tacit collusion

A form of collusion where firms indirectly coordinate actions without explicit agreements, often through price leadership. This practice can lead to higher prices and reduced competition, despite being difficult to prove legally.

Undercutting (cheating)

A practice in collusive oligopolies where a firm lowers its price below the agreed level to gain market share, which is perceived as 'cheating' by other firms. This behavior can destabilize collusive agreements.

A condition where production occurs at minimum average cost.

productively efficient

A theoretical market structure used as a benchmark for judging the performance of real-world markets.

perfect competition

State the formula: AR

AR = MR = P AR = TR / Q AR = P

State the formula: Long-run equilibrium: P

Long-run equilibrium: P = MC = minimum ATC In the long run entry and exit eliminate abnormal profits or losses so the firm operates where price equals marginal cost and average total cost is at its minimum.

State the formula: Profit-maximising rule: MR

Profit-maximising rule: MR = MC A perfectly competitive firm chooses output where marginal revenue equals marginal cost to maximise profit or minimise loss.

State the formula: Shutdown condition: P

Shutdown condition: P < AVC If price falls below average variable cost the firm shuts down in the short run because it cannot cover variable costs.

average total cost

Total cost per unit of output, found by dividing total costs by the quantity produced. It is central to profitability: a firm earns normal profit where price equals it.

The financial outcome when revenue surpasses or falls short of costs.

Profit / Loss

The situation where revenue matches total costs, resulting in no profit or loss.

Break-even position

A condition where firms' decisions are influenced by the expected actions of their rivals.

Strategic interdependence