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Market Structures and Economic Efficiency
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Market Structures and Economic Efficiency
Market Structures and Economic Efficiency
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1
Question
How is allocative efficiency achieved in a market?
Page 2
Answer
Allocative efficiency occurs when resources produce the goods and services consumers value most highly. It occurs where price equals marginal cost, or \(P=MC\), so social value equals the marginal cost of production.
2
Question
Why does productive efficiency require production at minimum average cost?
Page 2
Answer
Productive efficiency means producing output using the fewest resources possible. A firm must operate at the bottom of its average cost curve, where average cost is minimised and, in the short run, \(MC=AC\).
3
Question
How does dynamic efficiency differ from static efficiency?
Page 2
Answer
Dynamic efficiency concerns efficient resource allocation over time through investment, new products, and new production techniques. Static efficiency concerns efficiency at a particular point in time; allocative and productive efficiency are examples.
4
Question
Why is a firm X-inefficient at a particular output level?
Page 2
Answer
A firm is X-inefficient when it fails to minimise average cost for its actual level of output. This represents organisational slack and is a specific form of productive inefficiency.
5
Question
Why can weak competition create X-inefficiency?
Page 2
Answer
Weak competition gives firms little incentive to reduce costs. Without competitive pressure, organisational slack can persist and the firm may fail to operate on the lowest possible average cost curve.
6
Question
Why are firms in perfect competition described as price takers?
Page 3
Answer
Each firm faces many competing sellers and cannot influence the market price. Price is determined by market demand and supply, so the individual firm accepts that price and faces perfectly elastic demand.
7
Question
How do many buyers and sellers support perfect competition?
Page 3
Answer
They ensure that no individual buyer or seller can influence market price. Even a substantial change in one firm’s output or one buyer’s consumption has no significant effect on the market.
8
Question
Why does freedom of entry and exit prevent long-run supernormal profit?
Page 3
Answer
Supernormal profit attracts new firms, increasing market supply and reducing price. Losses encourage firms to leave, reducing supply and increasing price. These movements lead firms toward normal profit in the long run.
9
Question
How does perfect knowledge affect pricing under perfect competition?
Page 3
Answer
Firms know when other firms are earning profit and can enter attractive markets. Buyers know where identical goods are cheapest, so a firm charging above the market price sells nothing.
10
Question
Why must products be homogeneous in perfect competition?
Page 3
Answer
Homogeneous products are identical, so consumers cannot distinguish one firm’s product from another’s. A firm charging more loses customers, while charging less is unnecessary because it can sell all output at the market price.
11
Question
At what output does a profit-maximising firm produce?
Page 3
Answer
A profit-maximising firm produces where marginal cost equals marginal revenue, \(MC=MR\). This applies to the short-run equilibrium described for firms in perfect competition.
12
Question
Why do perfectly competitive firms earn only normal profit long term?
Page 3
Answer
Short-run supernormal profit attracts entry, shifting market supply outward and lowering price until average revenue equals average cost. Short-run losses cause exit, shifting supply inward and raising price toward normal profit.
13
Question
Why is perfect competition statically efficient?
Page 4
Answer
Perfectly competitive firms produce where \(MC=AC\), achieving productive efficiency, and where \(P=MC\), achieving allocative efficiency. Therefore, the market is both productively and allocatively efficient at equilibrium.
14
Question
Why is perfect competition unlikely to achieve dynamic efficiency?
Page 4
Answer
Individual firms may lack sufficient finance for research and development. Perfect information also allows competitors to copy innovations, reducing the original innovator’s competitive advantage and weakening its investment incentive.
15
Question
How can perfect competition create higher costs despite strong rivalry?
Page 4
Answer
Competition can keep prices and costs low, but firms may be unable to exploit economies of scale. Consequently, average costs may be higher than they would be in a more concentrated market.
16
Question
How does monopolistic competition differ from perfect competition?
Page 5
Answer
Both structures have many relatively small firms and freedom of entry and exit. Monopolistic competition differs because firms sell differentiated, non-homogeneous products and therefore possess some price-setting power.
17
Question
Why is the demand curve downward sloping under monopolistic competition?
Page 5
Answer
Product differentiation gives each firm some market power. Consumers may prefer one firm’s product, so the firm can raise price without losing every customer.
18
Question
Why do monopolistically competitive firms earn normal profit long term?
Page 5
Answer
Short-run supernormal profit attracts new firms because there are no barriers to entry. Entry reduces demand for each existing firm until average revenue equals average cost, producing normal profit.
19
Question
Why may the long-run profit prediction fail under monopolistic competition?
Page 6
Answer
Information may be imperfect, so potential entrants may not know that abnormal profits exist. Firms may also differ in size, costs, and products, allowing some firms to maintain supernormal profit.
20
Question
Why is monopolistic competition neither allocatively nor productively efficient?
Page 6
Answer
In long-run equilibrium, average revenue equals average cost, while profit maximisation requires \(MR=MC\). Because \(MR<AR\) for a downward-sloping demand curve, average cost cannot equal marginal cost or price.
21
Question
Why can monopolistic competition be dynamically efficient?
Page 6
Answer
Differentiated products give firms an incentive to innovate because successful innovation can create a competitive advantage and short-run supernormal profit. Small firms may nevertheless lack finance for investment.
22
Question
How does monopolistic competition affect consumers compared with perfect competition?
Page 6
Answer
Monopolistic competition generally provides greater product variety and may permit some economies of scale. However, it typically involves a higher price, lower output, and production above minimum average cost.
23
Question
What features define an oligopolistic market structure?
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Answer
An oligopoly has a few dominant firms with a high concentration of market share. Its key features are differentiated products, a high concentration ratio, interdependence, and barriers to entry.
24
Question
How is an n-firm concentration ratio calculated?
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Answer
The ratio measures the percentage of total market sales controlled by a specified number of firms. It can be calculated as \(\frac{\text{total sales of }n\text{ firms}}{\text{total market size}}\times100\).
25
Question
How does collusion change the behaviour of oligopolistic firms?
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Answer
Collusion involves collective agreements that reduce competition. Firms may cooperate to maximise industry profit, reduce uncertainty, and avoid mutually damaging price cuts or advertising competition.
26
Question
Why might firms refuse to participate in collusion?
Page 8
Answer
Collusion is illegal and creates risks that a cartel may break down. A strong firm with a distinctive business model may prefer to increase market share or charge more rather than cooperate.
27
Question
Under what conditions is collusion most likely to succeed?
Page 8
Answer
Collusion works best when there are few firms familiar with one another, similar costs and products, transparent production information, a dominant firm to follow, market stability, and high barriers to entry.
28
Question
How do overt and tacit collusion differ?
Page 8
Answer
Overt collusion involves a formal agreement between firms. Tacit collusion occurs without a formal agreement, for example through price leadership or unwritten restrictions on advertising and customer poaching.
29
Question
What is a cartel and how can it operate?
Page 8
Answer
A cartel is a formal agreement in which firms mutually set prices, usually through documented rules and possible fines for violations. Members may agree on a common price while competing through non-price methods or divide the market according to existing shares.
30
Question
Why is a cartel vulnerable to being broken by its members?
Page 9
Answer
Each member has a continuing incentive to undercut the agreed arrangement or produce differently to gain market share. The more successful the cartel, the greater the potential reward for the first firm to break it.