Market Structures and Contestability
Market Structures and Contestability
FREE RESOURCES
EXAM RESOURCES
PREMIUM
Allocative efficiency means producing the goods buyers want, in the quantities they want: no more and no fewer.
Picture a bakery that bakes many cakes but few loaves. Every evening cakes are unsold, while buyers who wanted bread found none. Moving some flour and oven time from cakes to bread would make buyers better off at no extra cost.
Allocative efficiency: when resources are used to produce the goods and services that consumers want, in the quantities they want.
Put simply, resources are allocated efficiently when no such move remains: each good is made in the quantity buyers would choose, given its cost.
The test compares two figures for the last unit made. The price shows what buyers are willing to pay for one more unit, so it measures how much they value it. Marginal cost (MC), the extra cost of producing one more unit, measures the resources that unit uses, which could have made something else.
If the price is above marginal cost, buyers value one more unit more than the resources it uses, so too little is being made. If the price is below marginal cost, the last unit uses resources worth more than the value buyers place on it. Those resources could make something buyers value more, so too much is being made. In both cases the output is allocatively inefficient. Only where P = MC is there nothing to gain from making more or less.
In Veltia, a country, Fenko makes biscuits and sells them at the market price of $4 a pack. At 500 packs a day, one more pack costs Fenko $4. So at 500 packs, P = MC: that is the allocatively efficient output. At 300 packs, MC is only $3, below the price, so Fenko makes too few. Above 500 packs, MC is higher than $4. One more pack then uses resources worth more than the $4 buyers are willing to pay for it, so Fenko makes too many: the mirror of making too few at 300 packs.
A firm is productively efficient when it makes its output at the lowest average cost it can reach.
Allocative efficiency asks whether the right quantity is made. Productive efficiency asks something else: is each unit made as cheaply as possible?
Productive efficiency: when goods or services are produced at the lowest possible average cost.
Put simply, the firm has found the output at which its average cost is lowest.
Average cost (AC), total cost divided by output, behaves like a class's average mark. A new mark below the average pulls it down; a new mark above it pulls it up.
Marginal cost (MC) is the extra cost of one more unit. While MC is below AC, the next unit costs less than the average, so AC falls. Once MC is above AC, the next unit costs more than the average, so AC rises. So AC is lowest where MC = AC: the MC curve crosses the AC curve at its lowest point.
Fenko, a biscuit maker in Veltia, has its lowest average cost, $3 a pack, at 300 packs a day, where MC is also $3. That is its productively efficient output.
The market price is $4 a pack:
At 300 packs, each pack costs as little as it can on average, but buyers value one more pack at $4 and one more pack costs only $3 to make: too few are made. At 500 packs, price equals marginal cost, so output is allocatively efficient, but each pack costs $3.20 on average, not $3. So Fenko meets one test and fails the other at each output: at 300 packs it is productively efficient only, and at 500 packs it is allocatively efficient only. Both are met only where the price equals the lowest average cost.
Exam Matters: On a cost diagram, mark productive efficiency where MC crosses AC at the lowest point of the AC curve. Mark allocative efficiency where the price line meets MC, which is usually a different output.
Dynamic efficiency is about costs falling and products improving over time, and it usually has to be paid for.
Allocative and productive efficiency judge a firm at one moment, with today's costs. Dynamic efficiency asks whether those costs fall, and the products improve, over the years.
Dynamic efficiency: improvements in efficiency over time, from new or better products and from new, cheaper ways of producing them.
Put simply, it is about next year's costs and products, not today's. A diagram shows one moment, so dynamic efficiency is not one point on it. When costs fall, the whole average cost curve moves down, because every output now costs less to make.
New machines and research cost money now and save money only later. A firm can borrow to pay for them, but many firms use profit they have already earned instead. So the kind of profit a firm earns matters.
Normal profit: the minimum profit needed to keep a firm in its current market.
Put simply, it is just enough to keep the owners' money in this market. Economists count it as part of average cost. So when average revenue (AR), the price received per unit, equals AC, the firm earns exactly normal profit.
Supernormal profit: profit above normal profit.
Put simply, it is money beyond what keeps the firm in its market, and the firm chooses what to do with it.
A firm earning only normal profit has little money to invest. A firm earning supernormal profit can pay for research and new machines itself. Competition gives it a reason to: if rivals find cheaper methods first, it loses buyers to them.
But the firm may pay the money to its owners instead, especially when no rival threatens its buyers. Supernormal profit makes dynamic efficiency possible, not certain.
Fenko, a biscuit maker in Veltia, sells at $4 a pack, above its average cost, so it earns supernormal profit. It spends part of that profit on a new oven. Over the next two years, its lowest average cost falls from $3 a pack to $2.50. Each pack now costs Fenko $0.50 less to make at its best output, and supernormal profit paid for the change: this is dynamic efficiency.
Exam Matters: Dynamic efficiency cannot be marked as one point on a diagram. Show it as the AC curve moving down over time, and say what paid for the move.
X-inefficiency is waste: a firm spends more than it needs to on the output it has chosen.
Productive efficiency asks which output has the lowest average cost. X-inefficiency asks whether a firm makes its chosen output as cheaply as it could.
X-inefficiency: when a firm's average cost is higher than the lowest average cost possible for the output it produces.
Put simply, compare the firm with itself at the same output: it could make that output for less, but it spends more. It wastes money at whatever output it chooses: staff paid for idle hours, or materials that spoil. The AC curve shows the lowest cost possible at each output, so an X-inefficient firm is above its curve.
Fenko, a biscuit maker in Veltia, could make 300 packs a day at $3 a pack. It actually spends $3.60 a pack.
Cutting waste takes effort. Suppose instead that Fenko's rivals sold the same biscuits at $3 a pack, not $4. Fenko could not charge much more than $3, so at an average cost of $3.60 it would lose $0.60 on every pack. Competition would force it to remove the waste or leave the market.
A firm with no close rival, which new firms find hard to challenge, feels much less of this pressure than Fenko would with close rivals. Its buyers have few other sellers to switch to, so it can cover the waste with a higher price for a long time. So X-inefficiency is more likely where competition is weak.
Exam Matters: Draw X-inefficiency as a point above the AC curve at the firm's own output. A point on the curve, away from its lowest point, shows productive inefficiency instead.
How many rivals a firm has, and how easily new firms can enter, decide how hard it is pushed to be efficient.
Fenko's efficiency depends partly on how Fenko runs its business and partly on the market around it: a biscuit maker with many close rivals faces different pressures from one that sells alone.
Market structure: the characteristics of a market that affect how the firms in it behave, such as the number and size of the firms, how similar their products are, and how easily firms can enter and leave.
Put simply, market structure is the shape of the competition a firm faces: who it competes with now, and who could join them.
Barriers to entry: obstacles that make it difficult or impossible for new firms to enter a market.
Put simply, barriers protect the firms already in a market from newcomers. A licence only one firm holds, or a factory that costs millions to build, can keep new firms out.
Economists group markets into four structures:
If a firm charges well above its costs, rivals can charge less and take its buyers. So with many rivals, the price is pushed down towards marginal cost: towards allocative efficiency. A firm whose costs are above its rivals' costs loses money at their price, so it must cut its costs towards the lowest possible. Where entry is free, supernormal profit also draws in new firms. Their extra output increases market supply, so the price falls and the supernormal profit shrinks. Entry stops when the supernormal profit has gone, so a firm cannot go on charging well above its average cost.
Barriers to entry weaken these forces. Behind high barriers, new firms find it difficult or impossible to enter and take the firm's buyers, so a price above marginal cost can last, and so can supernormal profit.
That lasting profit can pay for research and new machines, which is a source of dynamic efficiency. But with few rivals to lose buyers to, the firm also feels much less pressure on its costs than a firm in a competitive market, so X-inefficiency can grow. Which effect is larger depends on whether the firm invests its profit or pays it to its owners.
The more firms a structure has and the lower its barriers, the harder it pushes a firm towards allocative and productive efficiency: perfect competition, with very many firms and no barriers, pushes hardest, and monopoly, with one firm and very high barriers, pushes least.
A concentration ratio measures how much of a market its largest few firms hold between them.
In some markets, hundreds of small firms share the sales. In others, a few large firms make almost all of them. To compare markets, economists need a number for how much the largest firms hold.
That number is built from market shares. A firm's market share is its sales as a percentage of the total sales in the market. In Veltia, a country, cement is sold by the tonne, a weight of 1,000 kilograms. Brenvo makes 35 of every 100 tonnes of cement sold, so its market share is 35%.
Concentration ratio: the combined market share of the largest firms in a market.
Put simply, a concentration ratio tells you how many of every 100 sales in a market the biggest few firms make together. You choose how many firms to count, and that number is the n: a three-firm ratio adds the three largest shares.
Five firms make most of Veltia's cement: Norvik 15%, Brenvo 35%, Pelta 5%, Kovo 25% and Orbo 10%. Many small firms share the other 10%.
A four-firm ratio of 85% means that Brenvo, Kovo, Norvik and Orbo make 85 of every 100 tonnes of cement sold in Veltia.
The same market gives a different ratio for each n: 75%, 85% or 90% for cement. So a ratio cannot be read until you say how many firms it covers. Write "the four-firm concentration ratio is 85%", not "the ratio is 85%". When two firms merge, their market shares are added and the new firm counts as one firm. It may now rank higher, so work the ratio out again from the new ranking.
A high concentration ratio shows that a few firms hold most of a market, but not how they behave.
A concentration ratio is a quick first guide to a market's structure. A low ratio means many firms share the sales, as in the market structures called perfect competition and monopolistic competition. A high ratio means a few firms make most of the sales, which suggests the structure called oligopoly. A one-firm ratio close to 100% suggests a monopoly, a market with only one seller.
It only suggests a structure, because it counts one thing: the combined share of the largest firms. Four other things also decide how much competition there is.
How the shares are split between the firms. In Veltia, flour milling and cement have the same four-firm ratio, 85%, but different shares:
So cement is led by one large firm, while flour is shared by four mills of similar size. Only the shares, or a three-firm ratio, can tell the two apart.
How the firms behave. Four firms with 85% of a market might compete hard on price, or agree to keep their prices high. The ratio is the same either way, but buyers may pay different prices.
Whether new firms could enter. A barrier to entry is anything that makes it hard for a new firm to start selling. If barriers are low, a new firm could enter whenever prices rise far above costs, so even firms with a high ratio may keep their prices low, to give new firms no reason to enter. If barriers are high, the same firms could keep their prices high without losing sales to new firms.
How the market is defined. If Veltia's ratio counts only cement made in Veltia, it leaves out imported cement, which also competes for Veltia's buyers. A national ratio can also hide a local market: a town far from other cement works may have only one seller.
So use a concentration ratio to name the likely structure. Then check behaviour, entry and the market's definition before you judge the competition.
In perfect competition, each firm is too small to change the market price, so it must accept that price.
Imbro is a tomato farm in Veltia. It is one of many farms that grow tomatoes there, and its tomatoes are the same as every other farm's.
Perfect competition: a market structure with many buyers and sellers, identical products, perfect information, and freedom of entry and exit.
Put simply, no farm and no buyer is big enough, or different enough, to matter on its own.
The market price of tomatoes is set where market demand meets market supply. Suppose it is $20 a crate. If Imbro asked $21, buyers would buy identical tomatoes from another farm at $20, and Imbro would sell none. Asking less would gain nothing. Imbro grows only a tiny share of all the tomatoes bought, so it can already sell every crate it grows at $20.
Price taker: a firm that cannot influence the market price and must accept the price set by the market.
Put simply, the market tells the farm its price. The farm decides only how many crates to grow.
So the demand curve facing Imbro is a horizontal line at $20: it can sell any quantity at that price, and nothing above it.
Each extra crate sells for the same $20, so it adds exactly $20 to revenue. Average revenue (AR), the revenue per crate, is $20. Marginal revenue (MR), the extra revenue from one more crate, is also $20. For a price taker, AR = MR = P.
Exam Matters: Draw the market diagram beside the firm's diagram. Draw the price set where market demand meets market supply across to the firm, as a horizontal line labelled AR = MR = P.
A firm makes the most profit at the output where marginal revenue equals marginal cost.
Imbro, a tomato farm in Veltia, is a price taker: it sells every crate at the market price, $20. It chooses only its output. Which output gives it the most profit?
Marginal revenue (MR), the extra revenue from one more crate, is the $20 price. Marginal cost (MC) is the extra cost of one more crate. Imbro's MC rises as it grows more, because more pickers have to share the same land.
If the next crate adds more to revenue than to cost (MR above MC), growing it raises profit. If it adds more to cost than to revenue (MC above MR), growing it lowers profit. So the firm adds crates while MR is above MC, and stops where the two are equal.
Profit maximisation: producing the output at which marginal revenue equals marginal cost.
Put simply, the firm produces every unit that earns more than it costs, and no unit that costs more than it earns.
For Imbro, MR is the price, so the rule becomes P = MC. MC reaches $20 at 60 crates a day, so Imbro grows 60 crates.
Normal profit, the minimum profit needed to keep a firm in its market, is already counted inside average cost. So all $390 is supernormal profit, the profit above normal profit.
On a diagram, the $390 is a rectangle, $6.50 high and 60 crates wide. It is named by the letters at its corners, in order:
Supernormal profit is the rectangle WXYZ. This is Imbro's short-run equilibrium: Imbro grows the output where MR = MC. It lasts only in the short run, because new farms have not yet had time to start growing tomatoes.
Exam Matters: Label the firm's horizontal line AR = MR = P and mark the output where it meets MC. Read AC at that output, then shade the rectangle between the price and AC.
Supernormal profit draws new firms into the market until the price falls to the lowest average cost.
At $20 a crate, Imbro earns $390 a day of supernormal profit, the profit above normal profit, and so do the other tomato farms. Perfect information lets farmers outside the market see this profit. Freedom of entry lets them start growing tomatoes too, with the same methods and costs as Imbro.
Entry continues while farms earn supernormal profit, and it stops when that profit is gone. That happens only when the price has fallen to $12 a crate, Imbro's lowest average cost (AC). At any price above $12, Imbro grows where MC equals the price, and its AC at that output is below the price. So it still earns supernormal profit. At $12, marginal cost (MC) equals the price at 40 crates, where AC is also $12. So each farm now grows 40 crates, fewer than the 60 it grew at $20. The market as a whole still sells more tomatoes than at $20, because there are more farms.
Average revenue (AR), the price per crate, now equals AC, so revenue only just covers total cost. Normal profit is counted inside that cost, so Imbro earns normal profit and no supernormal profit. This is long-run equilibrium: no farm wants to enter or leave the market. In long-run equilibrium, P = MR = MC = AC, at the lowest point of AC.
Now suppose the price is $10 instead, below the lowest AC of $12. Every farm makes a loss at any output. Over the following months some farms leave, because their land and money can earn more elsewhere.
Market supply decreases, so at $10 the quantity demanded is now greater than the quantity supplied: a shortage (excess demand). The price rises until it is back at $12, where the farms that remain earn normal profit again.
Exam Matters: Draw the market and the firm side by side. Shift market supply to the right, read the lower price off the market diagram, and draw it across until the firm's horizontal line touches the lowest point of AC.
In the short run, a firm making a loss keeps producing while the price covers its average variable cost.
Suppose the price of tomatoes falls to $10 a crate. Imbro has a lowest average cost (AC) of $12. So it makes a loss at any output. Should it stop growing tomatoes now?
In the short run, that depends on which costs it can avoid. Its fixed costs, $120 a day for land and machines, must be paid even if it grows nothing. Variable costs, such as pickers, are paid only on crates it grows. Average variable cost (AVC) is the variable cost per crate. So in the short run Imbro compares the price with AVC, not with AC. If the price is above AVC, each crate pays its own variable cost and adds something towards the fixed cost.
Imbro's AVC is lowest, $8, at 25 crates a day, so 25 crates is the output where its variable costs are easiest to cover.
At $10, producing loses less, so Imbro keeps producing. A firm making a loss still chooses its output where MR = MC, because that output makes the loss as small as it can be. At $10 Imbro would really grow a little more than 25 crates, where its MC reaches $10. So its real loss is a little smaller than $70, and producing still loses less than closing. At $6 it closes, because $6 is below its lowest AVC, $8.
The rule: in the short run, keep producing while the price covers AVC, and close when the price is below the lowest AVC.
Shutdown point: the price at which a firm's revenue only just covers its variable costs, where price equals the lowest average variable cost.
Put simply, it is the lowest price at which producing is no worse than closing. For Imbro, it is $8 a crate.
In the long run no cost is fixed: Imbro can stop renting its land and sell its machines. If the price stays below its lowest AC, $12, Imbro makes a loss at every output, and in the long run it can avoid every cost by leaving. So for Imbro to stay, the price must reach $12. At $10, Imbro keeps producing in the short run but leaves in the long run.
Exam Matters: When a firm makes a loss, say which time frame you mean. In the short run, compare the price with AVC; in the long run, compare it with AC.
In the long run, a perfectly competitive firm is allocatively and productively efficient, but rarely dynamically efficient.
Here are the tests of efficiency for Imbro at $20 a crate in the short run and $12 in the long run.
Allocative efficiency needs the price to equal marginal cost (MC), the extra cost of one more crate. Imbro is a price taker, so its marginal revenue equals the price, and it grows where MR = MC. So whenever it produces, it produces where P = MC, in the short run and in the long run.
Productive efficiency needs output at the lowest average cost (AC). In the short run, the high price, $20, makes a larger output, 60 crates, more profitable than 40 crates, at an AC of $13.50, above the lowest, $12. In the long run, entry pushes the price down to the lowest AC, and Imbro grows the output where AC is lowest.
X-inefficiency, an AC above the lowest possible for the output, rarely lasts. In the long run the price equals the lowest AC, so a farm that wastes money has costs above the price. It makes a loss, and must remove the waste or leave.
Dynamic efficiency is where perfect competition is weakest. New methods are usually paid for from supernormal profit, and in the long run each farm earns only normal profit. Perfect information also means a cheaper method is quickly known to every farm, so other farms copy it at once, and the farm that paid for it keeps little of the gain. A farm has a strong reason to adopt a cheaper method that other farms have found, because otherwise its costs stay above the price and it makes a loss. But it has little money or reason to invent one.
In monopolistic competition, many firms sell products that are a little different, so each firm can set its own price within limits.
Think of the cafés in a busy part of a city. There are many of them, a new one can open within weeks, and each serves coffee a little different from the rest. Economists call a market like this monopolistic competition.
Monopolistic competition: a market structure with many firms selling differentiated products, with low barriers to entry and exit.
Put simply, each firm has many rivals and little protection from new ones. But it sells something its customers cannot get in exactly the same form anywhere else: this café's coffee, this barber's haircut.
Firms in both aim to maximise profit. With so many rivals, no firm plans around a particular one: each sets its price on its own.
In perfect competition, a firm that charged more than the market price would lose every buyer, because identical products are on sale everywhere else. So its demand curve is horizontal.
A differentiated product changes this. Mirelo, a café in Veltia, has customers who prefer its coffee, its seats or its staff. If Mirelo raises its price a little, some buyers switch to other cafés, but those who prefer Mirelo stay. So a higher price reduces the quantity demanded without reducing it to zero, and Mirelo's demand curve slopes down.
This gives Mirelo some control over its price. It can charge more and sell fewer cups, or charge less and sell more. But the control is small. Many close substitutes are nearby, so demand is price elastic, and a large price rise would lose most of its buyers.
A firm can make its product different in what it is, in how it is presented, or in where and how it is sold.
Mirelo, a café in Veltia, keeps its customers when it raises its price a little only if they see its coffee as different from the coffee next door. Making them see it that way is product differentiation.
Product differentiation: making a product different from rivals' products, or making it seem different, so that buyers see it as distinct.
Put simply, the product does not have to be better. What matters is that buyers see it as not quite the same, so they do not switch as soon as a rival charges a little less.
There are three types:
The key difference is whether the product itself changes. Physical differentiation changes the coffee. Marketing and distribution can work even when the coffee is the same as a rival's. Buyers may trust a name they know, or prefer the café that brings coffee to their desk.
Each type gives some buyers a reason to prefer Mirelo. Those buyers keep buying when Mirelo charges a little more than its rivals, so Mirelo's demand curve slopes down. The more strongly buyers prefer Mirelo, the less price elastic its demand: a price rise loses fewer of them.
But differentiation can be copied: a rival café can roast its own beans or deliver coffee too. Supernormal profit is profit above the normal profit a firm needs to stay in the market. Barriers to entry are low, so when Mirelo's differentiation earns supernormal profit, new cafés can open and copy it. Buyers then see Mirelo as less different, so their preference for Mirelo weakens.
A firm in monopolistic competition chooses its output where MR = MC, then reads its price off the demand curve at that output.
Mirelo, a café in Veltia, maximises profit where marginal revenue (MR) equals marginal cost (MC).
Mirelo's demand curve slopes down, so it can sell one more cup only by lowering its price. The lower price applies to every cup it sells, not only the extra one. So the extra cup adds its own price to revenue, but Mirelo receives a little less on every other cup.
Average revenue (AR) is total revenue divided by the number of cups, so AR is the price of each cup. The demand curve shows the price for each quantity, so it is also the AR curve. MR is below the price at every output, so the MR curve lies below the demand (AR) curve.
MR and MC are both $3 at 250 cups a day, so 250 cups is Mirelo's profit-maximising output.
But the price is not $3. MR = MC tells Mirelo how many cups to make, not what to charge. To find the price, read the demand curve at 250 cups, because it shows the highest price buyers will pay for each quantity.
AC includes normal profit, so this $500 a day is above the minimum Mirelo needs to stay in the market. On the diagram, this is the rectangle WXYZ. W is the point on the price axis at $5, and X is the point on the demand curve at 250 cups. Y is the point on the AC curve at 250 cups, and Z is the point on the price axis at $3. The rectangle's height, $5 − $3 = $2, is the supernormal profit on each cup. Its width, 250 cups, is the output, so its area is the $500 of supernormal profit.
Barriers to entry are low, so in the months that follow, other cafés can open nearby to earn some of that profit.
Exam Matters: Draw the MR curve below the demand curve, starting from the same point on the price axis and falling twice as steeply when the demand curve is a straight line.
New firms enter until each firm's demand curve just touches its average cost curve, leaving only normal profit.
In the short run, Mirelo earns $500 a day of supernormal profit: profit above the normal profit it needs to stay in the market. Barriers to entry are low, so over the following months new cafés open nearby. What entry changes is Mirelo's demand curve.
The new cafés sell close substitutes: coffee a little different from Mirelo's. Two things follow.
First, some of Mirelo's buyers move to the new cafés. So at every price, the quantity demanded from Mirelo is lower, and its demand curve shifts left.
Second, the buyers who stay now have more close substitutes. So if Mirelo raises its price, more of them switch to a rival. Its demand becomes more price elastic, and a more price elastic demand curve is flatter.
Both changes happen at the same time. Together, they lower the price Mirelo can charge for each quantity, so its supernormal profit shrinks.
Entry continues until the demand curve just touches (is tangent to) Mirelo's average cost (AC) curve, at 200 cups a day and $3.10. The two curves meet at this one point and do not cross.
At 200 cups the price equals AC (AR = AC): normal profit. At any other output Mirelo would make a loss, because AC is above the price. So 200 cups is its most profitable output, where MR = MC = $2.20. With no supernormal profit left, entry stops.
If too many cafés opened, Mirelo's demand curve would lie below AC at every output, so Mirelo would make a loss. Some cafés would exit, and their buyers would move to those that remain. With fewer close substitutes, Mirelo's demand curve would shift right and become less price elastic, until it touched AC again at 200 cups and $3.10.
AC is U-shaped. A downward-sloping demand curve can touch it without crossing it only where AC is also falling, to the left of its lowest point. Where two curves just touch, they slope the same way. The demand curve slopes down, so AC must slope down there too. At AC's lowest point AC is flat, so a downward-sloping demand curve would cross it. Mirelo's lowest AC is $3, at 250 cups, but it makes only 200.
Excess capacity: when a firm produces less than the output at which its average cost would be lowest.
Put simply, Mirelo could serve 50 more cups a day at a lower cost per cup. It does not, because to sell them it would have to charge less than its average cost.
Exam Matters: Draw the long-run demand curve to the left of the short-run one and flatter, touching AC once. Show MR crossing MC at the same output as the tangency.
In the long run, a firm in monopolistic competition fails both the allocative and the productive efficiency tests, but its buyers get variety in return.
In long-run equilibrium, Mirelo sells 200 cups a day at $3.10, where its demand curve just touches its average cost (AC) curve.
Allocative efficiency means resources are used to make the goods buyers want, in the quantities they want. It needs the price to equal marginal cost (MC). At 200 cups, the price, $3.10, shows what buyers are willing to pay for one more cup. That is more than the $2.20 it costs to make, so too few cups are made. This follows from the downward-sloping demand curve. MR is below the price, so where MR = MC the price is above MC.
Productive efficiency needs each unit made at the lowest possible cost: the lowest point of the AC curve. Mirelo's lowest AC is $3, at 250 cups. But Mirelo makes only 200 cups, where each cup costs $3.10.
The 50 cups a day between 200 and 250 cups are its excess capacity. Because of it, each cup costs $0.10 more than the lowest AC Mirelo could reach, $3.
In the short run, Mirelo makes 250 cups, the output at its lowest AC, so it is productively efficient then. But its short-run price, $5, is $2 above MC, $3. In the long run the gap is only $0.90, so in the short run Mirelo is further from allocative efficiency.
Dynamic efficiency means products and methods improve over time, and it needs investment in new products and methods. In the long run Mirelo earns only normal profit, so it has little to invest. But differentiation gives it a reason to continue to improve: a new drink or a better service wins buyers, at least until rivals copy it.
Perfect competition would give one identical product at the lowest AC. Here buyers choose between many cafés, each with its own coffee, seats and location. If buyers value that variety more than the extra $0.10 a cup above the lowest AC, the higher cost is worth paying.
So the two efficiency failures are facts, but whether they make this structure bad for buyers is a judgement. That judgement depends on how much buyers value variety, and how different the products really are.
Exam Matters: When you judge this structure, compare its allocative and productive failures with the variety buyers get, and say what the judgement depends on.
In an oligopoly, a few large firms sell most of the output, so each firm must think about how its rivals will react.
In Veltia, a country, five cement makers sell most of the cement. Brenvo, the largest, holds 35% of the market, and Kovo, the second largest, holds 25%. Together the five largest firms hold 90%: Veltia's five-firm concentration ratio for cement is 90%. A market like this, with a few large firms, is an oligopoly.
Oligopoly: a market structure in which a few large firms supply most of the market.
Put simply, a buyer in an oligopoly has only a few real choices of seller, and each seller is large enough to change the whole market by what it does.
Interdependence: when the decisions of one firm affect its rivals, so each firm must consider how its rivals will react.
Put simply, an oligopolist cannot set its price by looking only at its own costs and buyers. It must also ask what its rivals will do next.
Suppose Brenvo cuts its price of cement. Brenvo is large, so the lower price would take many of Kovo's buyers. Kovo cannot ignore this, so it may cut its own price to keep them. Brenvo would then keep few of the buyers it took from Kovo, and sell at a lower price. So before Brenvo changes its price, it must judge how Kovo will react.
Interdependence sets oligopoly apart from the other market structures. A firm in perfect competition has so many rivals that no single one matters to it. A monopoly has no rival at all. A café in monopolistic competition has many rivals, and its price change is too small for any one of them to react to. Only in an oligopoly does each firm plan around a few rivals who are planning around it.
A large firm can make each unit more cheaply than a new firm, and it can use that gap to keep new firms out.
Barriers to entry are what keep an oligopoly's few firms few. Two barriers work together: the cost advantage of a large firm, and the low price it allows.
Economies of scale: the fall in long-run average cost as a firm increases its scale of production.
Put simply, a bigger firm can often make each unit more cheaply. A large kiln uses less fuel for each tonne than a small one, and one manager can run a much larger plant.
Brenvo makes cement on a large scale, so its average cost (AC), the total cost divided by the number of tonnes, is $40 a tonne. A new firm would start small, because it begins with few buyers. At that small scale, its AC would be $50 a tonne. So Brenvo can charge a price that a new firm cannot match without making a loss.
Limit pricing: setting a price low enough to stop new firms entering a market, below the average cost a new entrant would face.
Put simply, the firm already in the market sets its price just below a newcomer's costs, so entering would not pay.
So the limit price sits between the two average costs: below the new firm's $50 and above Brenvo's own $40. Brenvo loses $12 of profit on each tonne today, the difference between $20 and $8. In return, it makes entry unprofitable for new firms, so it keeps its buyers.
Why not charge $60 and let a new firm enter? At $60, a new firm would earn $10 a tonne above its average cost, so it would enter and take some of Brenvo's buyers. The limit price stops entry before it happens. It works only while the cost gap lasts. A new firm that could start on a large scale would have an AC closer to $40, and the limit price would then have to be lower.
Exam Matters: When you explain limit pricing, compare the price with two costs: it must be below a new firm's average cost and above the firm's own.
A new firm can be kept out by another firm's patent, by buyers' loyalty to a brand, or by the government's refusal of a licence.
Economies of scale give a large firm a cost advantage. Three other barriers work differently. Each blocks something a new firm needs: the right to use a method, buyers who trust its name, or permission to sell at all.
Patent: a legal right that gives an inventor the sole right to make and sell an invention for a set number of years.
Put simply, a patent makes the inventor the only seller of a new product or method for a time. No rival may copy it, however much money the rival has.
A patent is a barrier that ends. When its years are over, any firm may copy the invention, so new firms can enter. Governments grant patents on purpose: the years of protected profit reward a firm for the cost of inventing.
Buyers who know and trust a brand tend to keep buying it. A new firm must persuade those buyers to switch, usually through years of heavy advertising. It has to pay for this before it sells much, and it cannot recover the money if it fails and leaves. So a strong brand raises both the cost and the risk of entering.
Here the law itself limits who may sell. Veltia's national government licenses only three mobile networks: Sundo, Yelko and Zamo. A firm needs a licence to run a network, and no fourth licence is offered. So Veltia's mobile market has three firms because of the law, whatever a fourth firm's costs or brand might be.
Each of these barriers protects the firms already in the market from new rivals. The supernormal profit of those firms, the profit above the normal profit needed to keep them in the market, can therefore last longer.
Money a firm cannot recover if it leaves makes entering a market riskier.
Entering a market costs money. What matters to a new firm is not only how much it spends, but how much of that spending it could recover if it failed and left.
Sunk cost: a cost that cannot be recovered if a firm leaves the market.
Put simply, a sunk cost is money a firm cannot recover if it closes, because nobody will buy what it paid for.
If the new firm fails, it can sell its trucks, but the $50 million spent on the kiln is lost. The test is whether a cost can be recovered, not how large it is. Advertising is usually sunk: a campaign that made buyers know a brand cannot be sold to anyone when the firm leaves.
A firm thinking of entering knows it may fail. The more of its spending is sunk, the more it would lose by failing. So high sunk costs make entry riskier, and fewer firms try.
Sunk costs also make firms slow to leave. Once Brenvo has built its kilns, that money is lost whether Brenvo stays or leaves. So Brenvo stays as long as its revenue covers the costs it can still avoid, such as fuel and wages. So a new firm knows that the firms already in the market will stay, even when prices fall. They will compete hard for their buyers, and that makes entering riskier still.
In a two-firm game, each firm's best move can leave both firms worse off.
Interdependence means each firm must judge how its rival will react. Game theory gives the firm a way to reason about that judgement.
Game theory: the study of how firms make decisions when the result for each depends on what its rivals do.
Put simply, game theory lists every pair of choices the firms could make and the profit each firm earns from each pair, then asks what each firm will choose.
Brenvo and Kovo, Veltia's two largest cement makers, can each hold their price or cut it. The table gives each firm's profit, in $ million a month, for each pair of choices, with Brenvo's profit first.
A firm that cuts alone takes buyers from its rival, so it earns 12 and the rival only 2. If both cut, neither gains buyers and both sell at the lower price, so each earns 5.
Dominant strategy: a choice that gives a firm its best result whatever its rival does.
Put simply, a dominant strategy is the right choice even when a firm does not know what its rival will do. For Brenvo, cutting is dominant.
Kovo's profits mirror Brenvo's. If Brenvo holds, Kovo earns 12 by cutting and 8 by holding. If Brenvo cuts, Kovo earns 5 by cutting and 2 by holding. So cutting is dominant for Kovo too. Both cut, and each earns $5 million a month. Yet if both had held, each would have earned $8 million. Each firm makes the best choice for itself, and together they reach a result that is worse for both.
This explains two things. First, prices can fall again and again, because when one firm cuts, matching the cut is the rival's best reply. Second, each firm would gain $3 million a month if both agreed to hold. So oligopolists are tempted to make agreements, even though each could still earn more by breaking one: if the rival holds, cutting earns 12, not 8.
Exam Matters: With a payoff table, take the rival's choices one at a time, and compare what the firm earns from each of its own choices.
Firms in an oligopoly can earn more by agreeing not to compete, but each such agreement is hard to keep.
In Brenvo and Kovo's game, each firm earns $8 million a month if both hold their price, against $5 million if both cut. So both firms have a reason to agree not to compete on price.
Collusion: an agreement between firms to limit competition between them, for example by fixing prices or output.
Put simply, colluding firms act together like one large firm, instead of competing for the same buyers.
Tacit collusion: collusion without a formal agreement, where firms follow each other's prices.
Put simply, tacit collusion is an understanding that nobody writes down or says aloud: each firm simply avoids undercutting the others.
Non-collusive behaviour is the opposite: each firm sets its own price and competes for buyers. Which of the two happens depends on the conditions in the market.
Two forces push towards competition. The first is the gain from cheating. If Kovo keeps to an agreed price, Brenvo earns 12 instead of 8 by cutting. If a cut is seen and matched, both firms earn 5, less than the 8 each earned by holding. So an agreement lasts only while each firm expects that its rival would see a cut at once and match it. The second is the law. Agreements to fix prices are illegal in many countries, and firms found colluding can be fined.
Firms can collude openly, through a formal agreement, or quietly, by following one firm's price.
Cartel: a formal agreement between firms to fix prices or output.
Put simply, the members of a cartel agree what to charge or how much each will sell, and each is expected to keep to its share.
To raise the price, a cartel restricts the total output of its members. Each member gets a quota: the most it may sell. The higher price then earns each member more profit on every unit it sells.
At the cartel's high price, each extra unit a member sells earns a large profit. So every member gains by selling more than its quota, as long as the others keep to theirs. This is the choice in Brenvo and Kovo's game: cutting while the rival holds earns 12 instead of 8. If several members sell above their quotas, total output rises and the price falls. The members who kept to the agreement then stop keeping to it.
Cartels are illegal in many countries, because they raise the prices buyers pay. A competition authority that finds the agreement can fine its members, which gives each member another reason to leave.
Price leadership: when one firm, usually the largest, sets a price and the other firms follow it.
Put simply, the leader moves first and the others copy it, so prices move together without any meeting.
Price leadership is a form of tacit collusion. Suppose Brenvo, Veltia's largest cement maker, raises its price, and Kovo and the others raise theirs a few days later. Nobody has agreed anything. Each follower judges that matching Brenvo earns more than undercutting it. If a follower undercut, Brenvo could cut its price again, and repeated cuts would leave every firm earning less. Because there is no agreement to find, price leadership is much harder for the law to act against than a cartel.
Collusion usually helps the colluding firms and costs their buyers, but workers and governments gain in some ways and lose in others.
Suppose Veltia's cement makers collude: they restrict their output and raise the price of cement. Who gains and who loses depends on the group.
For consumers, the costs are usually larger. They pay more for every tonne they buy, at once, while any benefit from new kilns is uncertain and comes later. The higher price also spreads: builders who use cement pay more, and may charge their own buyers more.
For the firms, the benefit is profit, and the question is what happens to it. Profit spent on new kilns and research can lower costs over time. This is a source of dynamic efficiency: efficiency that improves over time, through new methods and new products. Profit simply paid to the owners helps only them. The effects also depend on how long the agreement lasts. The gain from cheating breaks many agreements, and a strong competition authority makes them riskier.
Price competition takes three forms, and each has a different aim: winning buyers, removing a rival or stopping entry.
Price competition means trying to win buyers by charging less. In an oligopoly, it takes three forms.
Price war: when rival firms repeatedly cut their prices to win customers from each other.
Put simply, in a price war each cut is matched, so firms keep cutting while none of them gains buyers.
Brenvo and Kovo's game shows why it happens: whatever the rival does, cutting is each firm's best move. Buyers gain from the lower prices while the war lasts. A war usually ends when the losses grow too large. One firm raises its price and waits for the others to follow, or the weakest firm leaves. If a firm leaves, fewer firms remain, and the price can end higher than before the war.
Predatory pricing: setting a price below average variable cost to force a rival out of the market, then raising the price once the rival has gone.
Put simply, the predator accepts a loss now so that it can own the market later.
Brenvo's average variable cost (AVC), the cost of fuel, wages and other inputs for each tonne, is $35. In the region where Pelta, a small cement maker, sells, Brenvo cuts its price to $30. It loses $5 on every tonne, before its fixed costs are even counted. Brenvo accepts this loss because it earns profit in its other regions, while Pelta is smaller and has less money to cover its own losses, so Pelta must leave first. Once Pelta has gone, Brenvo raises its price again.
Limit pricing is the third form: Brenvo's price of $48 is below a new firm's average cost of $50, so entry does not pay.
Predatory pricing pays only if, once Pelta has gone, barriers to entry stop new firms entering when Brenvo raises its price. It is illegal in many countries when a large firm uses it to remove rivals.
Oligopolists often compete without cutting prices, because a better product is slower to copy than a lower price.
Non-price competition: competing by any means other than price, such as advertising, branding, quality, endorsement, product placement and after-sales service.
Put simply, the firm tries to make buyers choose it while it charges much the same price as its rivals.
Veltia's three mobile networks, Sundo, Yelko and Zamo, charge similar monthly prices. They compete in five other ways:
A price cut is easy to see and quick to copy. If Sundo cuts its price, Yelko and Zamo can match it within days, because matching is each rival's best reply. All three then keep their buyers but earn less on each sale. A better network or a trusted brand takes rivals years to copy, so the buyers it wins tend to stay.
Non-price competition can also make demand for a firm's product less price elastic. Buyers who are loyal to Sundo keep buying even if its price rises a little. So Sundo can charge a little more than its rivals without losing many of them.
Price and non-price competition both bring costs and benefits, and these fall differently on each group.
Price and non-price competition affect four groups: firms, consumers, employees and suppliers. Think of Veltia's mobile networks, Sundo, Yelko and Zamo, competing in each way.
Each kind of competition brings each group some gains and some losses. Take consumers. Price competition gives them lower prices now. But if it forces a network out, fewer firms remain, and prices may rise later. Non-price competition gives them better service, but they pay for the advertising in the price, and some advertising only persuades without telling them anything useful.
Employees and suppliers also gain in some ways and lose in others. Price competition presses on their pay and their prices, while non-price competition creates skilled work and rewards suppliers who deliver higher quality. The overall effect depends on two things. The first is whether price competition lasts, or ends with fewer firms and higher prices. The second is whether spending on non-price competition improves the product, or only makes the brand better known.
A monopoly is the only seller of a good with no close substitutes, and barriers to entry keep it that way.
In every other market structure, a firm has rivals. A monopoly is the extreme case: one firm is the whole market.
Pure monopoly: a market with only one seller of a good that has no close substitutes.
Put simply, if you want the good, only one firm can sell it to you, and nothing else does the same job well enough.
The model of pure monopoly rests on three assumptions:
Delvo is the only maker of a patented insulin pen in Veltia, a country. Its users cannot switch to a similar pen, because no other firm may make one.
Monopoly power: the ability of a firm to set its price above the level a competitive market would set.
Put simply, it is the power to charge more than competition would allow, and a firm need not be the only seller to have it.
Pure monopoly is rare. But a firm with a large market share can act much like a single seller. So in many countries, the competition authority investigates such a firm for monopoly power.
A monopoly lasts only as long as its barriers. Most are the barriers of oligopoly, at their strongest, with one more, control of a resource:
Barriers to exit matter too. If leaving means losing a large sunk cost, entering is riskier, so fewer firms try. Some barriers also end: when Delvo's patent expires, other firms may make the pen.
A monopoly makes the most profit where MR = MC, and barriers to entry let that profit last in the long run.
A monopoly sets its price, but its demand curve is the whole market's demand curve, so a higher price means fewer sales.
Like any profit-maximising firm, it produces where marginal revenue (MR), the extra revenue from one more unit, equals marginal cost (MC), the extra cost of one more unit. Because its demand curve slopes downwards, a monopoly must lower its price on all its pens to sell one more, so its MR is below the price. It then charges the price buyers will pay for that output, read off the demand curve, never off MR.
So Delvo earns $2,000 a day above the normal profit it needs to stay in the market.
On the diagram, this profit is the rectangle WXYZ. W is the point on the price axis at $30, and X is the point on the demand curve at 400 pens. Y is the point on the AC curve at 400 pens, and Z is the point on the price axis at $25. The rectangle's height is the $5 profit on each pen, and its width is the 400 pens.
Where entry is free, supernormal profit draws in new firms until only normal profit is left. Delvo's patent stops new firms entering, because no other firm may make the pen. So the $2,000 a day can last in the long run, for as long as the patent does.
Exam Matters: When you draw a monopoly, mark the output where MR cuts MC. Go up to the demand curve for the price, then draw the profit rectangle between that price and AC at that output.
A monopoly usually means a higher price and less output, but its size and its profit can also bring benefits.
To judge a monopoly, compare it with a competitive industry that has the same costs. In a competitive industry, the price is pushed down towards marginal cost (MC), the extra cost of one more unit.
Delvo, Veltia's insulin-pen monopoly, charges $30 a pen, but the MC of its 400th pen is only $20. Buyers would pay more than $20 for some extra pens, yet Delvo does not make them, because beyond 400 pens each extra pen adds less to revenue than to cost. So a competitive industry with Delvo's costs would make more pens and sell them at a lower price.
The costs to consumers are close to certain, because a profit-maximising monopoly charges a price above MC. The benefits are possible, not certain. Economies of scale give consumers a lower price only if the monopoly lowers its price as its costs fall. Profit funds research, a source of dynamic efficiency, only if the firm spends it on research rather than paying it to its owners.
So the answer depends on the market. A monopoly with large economies of scale, which spends its profit on better products, may serve consumers better than many small firms could. A monopoly with no such savings, which keeps its profit and lets its costs rise, serves them worse than competition would.
Exam Matters: When you weigh a monopoly's benefits, give the condition each one needs, such as lower costs reaching buyers as lower prices. Then use the case to say whether it holds.
In a natural monopoly, one firm can supply the whole market more cheaply than two firms could.
Some goods need a costly network before the first customer is served: water pipes, power cables, railway track. The network costs about the same however much it carries. So the more a firm supplies, the more units share that cost, and the lower its average cost, total cost divided by output.
Natural monopoly: a market in which one firm can supply the whole market at a lower average cost than two or more firms could.
Put simply, the market is only big enough for one network. Two firms would each build a network and each serve fewer customers, so each unit would cost more.
Ostra Water supplies water to Minto, a town in Veltia. Its pipe network costs $9,000 a day, whatever it supplies. Each unit of water, a thousand litres, costs $1 more to deliver. Minto uses 3,000 units a day.
The same water costs $7 a unit with two firms and $4 with one. The extra $3 comes from the second network: Minto would pay for two sets of pipes but use no more water.
Competition usually pushes costs and prices down. Here it would raise costs, because each new firm adds another network. So one supplier is the cheapest way to serve Minto.
But a natural monopoly is still a monopoly. Left alone, Ostra would produce where marginal revenue equals marginal cost and charge a price above marginal cost, the extra cost of one more unit. So governments often regulate natural monopolies, for example with a price cap, the highest price the firm may charge. Some own them instead.
A firm with monopoly power can sometimes charge different groups different prices for the same good.
Rimbo Rail is Veltia's only passenger rail company. A trip at the peak, when people travel to work, costs $10. The same trip off-peak costs $6. The train, the seat and the journey are the same. So is the marginal cost, the extra cost of one more trip: $2 at either time.
Third-degree price discrimination: charging different groups of consumers different prices for the same good or service, where the difference is not due to differences in cost.
Put simply, the firm sorts its buyers into groups. Some groups pay more because they will pay more, not because they cost more to serve.
Why charge two prices? Peak travellers are mostly commuters who must reach work on time. Their demand is price inelastic: the quantity demanded falls by a smaller percentage than the fare rises, so a higher fare loses Rimbo few of them. Off-peak travellers, such as students and retired people, can travel another way or not at all. Their demand is price elastic: the quantity demanded rises by a larger percentage than the fare falls, so a lower fare wins Rimbo many more trips. Two prices earn Rimbo more profit than one, and the group with price-inelastic demand pays the higher price.
Price discrimination works only when all four conditions hold:
Price discrimination raises the firm's profit, but some consumers pay more while others pay less.
Rimbo Rail, Veltia's only passenger rail company, charges commuters $10 for a peak trip and other travellers $6 off-peak. Each trip costs it $2 at either time. Its effects differ from group to group, so judge them one group at a time.
Compare the two prices with one price for everyone. A single fare near $10 would lose many off-peak travellers, whose demand is price elastic. A single fare near $6 would charge commuters far less than they would pay. So the most profitable single fare would lie between $6 and $10.
For the firm, the benefit is clear: more profit, which can pay for new trains or keep loss-making services running. For consumers, the answer depends on the group. Commuters lose, because they pay more than at a single fare. Off-peak travellers gain, and some can travel only because of the lower fare.
So price discrimination is more likely to benefit consumers when it lets a group buy that would not buy at one price, or keeps a service running. It is more likely to harm them when it only raises the price for buyers whose demand is price inelastic.
A monopoly is likely to fail the two static efficiency tests, and it is dynamically efficient only if it invests its profit.
Apply the efficiency tests to Delvo, Veltia's only maker of a patented insulin pen. At its profit-maximising output of 400 pens a day, the price is $30. Its marginal cost (MC), the extra cost of one more pen, is $20, and its average cost (AC), total cost divided by output, is $25.
So a monopoly is likely to fail both static tests, which judge one moment in time. It passes the dynamic test only if it invests its profit.
The three tests across the four structures, in the long run:
The table shows a trade-off. Perfect competition is better for the static tests, because rivals push the price to MC and costs to the lowest AC; monopolistic competition and monopoly both fail them. Barriers are better for paying for research, because they let supernormal profit last. A monopoly's dynamic gain outweighs its static losses only if it spends that profit on research.
Exam Matters: When you judge a monopoly's efficiency, take each test separately, then weigh the losses on the static tests against the dynamic gain the case makes likely.
When a firm is the only buyer and pays one price to every seller, buying one more unit means paying a higher price for every unit.
Market structures count the sellers. Monopsony is about the buyer.
Monopsony: a market with a single buyer.
Put simply, it is a monopoly on the buying side. In a town with one large factory, a worker wanting a factory job has one place to ask.
Ulmo Garments, the only large employer in Pruno, a town in Veltia, pays every worker the same wage. To attract more workers, it must offer a higher wage, because each extra worker has to be drawn away from another job or from not working. Its supply of labour shows the wage that attracts each number of workers:
So the extra cost of a worker is above the wage, because the higher wage goes to every worker. This extra cost is the marginal cost of labour: "marginal" means the change from one more unit.
Ulmo, a profit maximiser, compares this cost with the marginal revenue product: the extra revenue from one more worker's output. It falls as more workers share the same machines. For Ulmo, the 100th worker adds $20 a day to revenue, and each worker before that adds more.
Ulmo pays the lowest wage that attracts 100 workers. The supply of labour shows this wage: $10.
A competitive labour market shows what the monopsony changes. If many employers competed for Pruno's workers, hiring one more would not raise anyone else's wage. Employment would then reach 150 instead of 100, at $15 a day instead of $10, where the wage equals the $15 that the last worker adds to revenue.
A monopsony lowers its costs by paying lower wages, so much of its gain is its workers' loss.
Ulmo Garments, the only large employer in the town of Pruno, hires 100 workers at $10 a day. Competing employers would hire 150 at $15. Comparing the two outcomes shows who gains and who loses.
For the firm, the lower wage, $10 instead of the $15 that competing employers would pay, cuts its costs and raises its profit. Each worker earns $5 a day less than in a competitive market, so workers have a reason to leave when another employer offers a job, and Ulmo may find it harder to keep its staff.
For employees, the monopsony is mostly a cost. Each of the 100 workers earns $5 a day less, and 50 people who would work for $15 are not hired.
For consumers, it depends on the market where Ulmo sells. If its garments compete with many other makers' garments, a higher price would lose it buyers. Lower costs let Ulmo charge a lower price to win more buyers and still make a profit. So consumers are likely to be charged lower prices. If Ulmo has few rivals when it sells, it can keep the saving as profit, and consumers are charged no less.
A government can change this outcome by law. Suppose Veltia's government sets a minimum wage of $12 a day.
In this model, any minimum wage between $10 and $15 raises both, and at $15 employment reaches 150. Above $15, the 150th worker adds less to revenue than the wage, so fewer than 150 are hired.
So the firm gains much of what its workers lose. Consumers share that gain only if the firm faces competition where it sells. How much workers lose depends on whether they could find work elsewhere, and on a minimum wage.
A market is contestable when new firms could enter it and leave it easily, however many firms are in it today.
Market structures are described by the firms inside a market. Contestability looks at firms that do not sell in the market yet. It asks how easily one of them could start selling there, and stop again.
Contestable market: a market in which there are few or no barriers to entry and exit, so new firms can enter and leave easily and at little cost.
Put simply, an outsider could start selling in a contestable market next month, and leave again without losing much money. Leaving matters as much as entering: a firm that knows a failed entry would cost little is far more willing to try.
A concentration ratio measures the share of a market's sales that its largest few firms hold today. Contestability asks how easily another firm could join them. A market with one firm can be highly contestable, if another firm could join it easily. A market with ten firms can be far less contestable, if a licence keeps new firms out.
Kovan and Ostel are two towns in Veltia, a country. Zenko Air is the only airline flying between them. Its average cost (AC), the cost per seat, is $60, and today it charges $80.
Yet the route is highly contestable. Landing slots at both airports are open to any airline, so entry is easy. Aircraft can be leased and moved to other routes, so leaving costs little. So Valdo, an airline on other routes, could start flying from Kovan to Ostel, and stop again. If Valdo entered and charged $70, Zenko's $80 price would not last.
Exam Matters: When you describe a contestable market, name both conditions: low barriers to entry and low barriers to exit. Then say which fact in the case makes each one low.
In a contestable market, the threat of entry can keep even a single firm's price close to its average cost.
Zenko Air is the only airline on the Kovan–Ostel route. Its average cost (AC), the cost per seat, is $60. Economists count normal profit, the minimum profit that keeps a firm in its market, as part of AC. So when Zenko charges $80, it earns $20 a seat of supernormal profit.
Valdo, an airline on other routes, can see that profit. It uses the same kind of aircraft, so its AC on the route would also be about $60. If it entered and charged $70, the supply of seats on the route would increase, the price would fall from $80 to $70, and Zenko's supernormal profit would shrink. Valdo would earn $10 a seat of supernormal profit.
Valdo would not need to stay. When the profit had gone, it could move its leased aircraft back to its other routes. Little of its cost of entering would be sunk, so leaving would cost it little.
Hit-and-run entry: entering a market to take its supernormal profit, then leaving when the profit has gone.
Put simply, the entrant comes for the profit and leaves when it ends, which it can do only because leaving costs little.
Zenko cannot wait for Valdo to arrive. Valdo could sell its seats at $70 and leave again before Zenko had time to cut its own price. So Zenko lowers its price close to $60 now, before any airline enters. At that price, an airline with the same costs would earn only normal profit, so Valdo has no reason to enter.
So Zenko earns about normal profit, like a firm with many rivals. Suppose instead that only Zenko had a licence to fly the route. The route would then not be contestable, and Zenko could keep its $80 price and its supernormal profit for as long as the licence lasted.
Zenko's price is a limit price: a price low enough that an entrant would earn no supernormal profit, so no firm enters. How low it must be depends on the entrant's AC. Valdo's AC would be the same as Zenko's, about $60. So Zenko's limit price is close to $60, and almost no supernormal profit is left.
Exam Matters: When you explain why a single firm keeps its price low, name the fact in the case that makes entry and exit cheap. Without it, the threat of entry is not believable.
Contestability usually gives consumers lower prices, but it can leave firms with too little profit to invest.
In a contestable market, the threat of entry keeps prices close to average cost (AC), the cost per unit, including normal profit.
Consumers pay lower prices. On the Kovan–Ostel route, passengers pay close to $60 a seat, not $80, although Zenko Air is the only airline. At the lower price the quantity demanded is greater, so more passengers fly.
Consumers also gain because firms must keep their costs low to hold those prices. A firm that wastes money has an AC above the lowest an entrant could reach, so a price close to the entrant's AC would give it a loss. So the threat of entry pushes it to remove X-inefficiency, costs above the lowest possible for its output.
Investment may be slower than where firms keep supernormal profit. Many firms pay for new equipment and better products out of supernormal profit. A firm held to about normal profit has less to invest, so dynamic efficiency, improvements over time, may come more slowly.
Service may also be less stable. A hit-and-run entrant serves a market only while it earns supernormal profit, then leaves. Customers who came to rely on it lose that service when it goes.
A firm already in the market earns less supernormal profit than it would if rivals could not enter. For firms outside the market, contestability is a benefit: they can enter whenever a market earns supernormal profit.
The benefits are largest where sunk costs really are low and the product needs little long-term investment, such as an air route. They are smaller where the product needs investment that pays back only over many years, such as a rail network. Track and stations cannot be moved or sold for much, so these high sunk costs make entry harder and the market is less contestable. A firm held to normal profit may also not make that investment, which raises the cost to consumers. The benefits also last only while entry and exit stay cheap: a new licence, or new sunk costs, would weaken the threat of entry.
Exam Matters: When you weigh contestability, judge it for the case: how low the sunk costs really are, and how much long-term investment the product needs.
Among the costs of entering, the part a firm cannot get back matters most for contestability, not the total.
A sunk cost is a cost that cannot be recovered if a firm leaves the market. Sunk costs matter most for contestability, because an entrant that cannot get its money back risks losing it, and a firm unwilling to take that risk does not enter.
A firm deciding whether to enter weighs two amounts: the cost of entering, and the part of it the firm would lose if it left. The second matters more.
Consider Valdo deciding whether to fly the Kovan–Ostel route. Its largest cost is leasing aircraft, but this cost is not sunk: if the route does badly, Valdo moves the aircraft to its other routes. Its sunk costs are about $200,000 of advertising and staff training for this route: the adverts and the route training are of no use anywhere else. Valdo cannot get that money back if it leaves.
So Valdo risks only the $200,000 of sunk costs, not the cost of leasing, which it can recover. At the $10 a seat of supernormal profit that Valdo would earn by charging $70, it earns back $200,000 once it has sold 20,000 seats, so it need not stay long, and the route stays contestable. The reverse case also holds: a small total cost can be mostly sunk. A new soft-drink brand may cost little to start, but most of that money goes on advertising, which cannot be resold. That market is less contestable than its low total cost suggests.
Hit-and-run entry pays only if leaving costs little. If Valdo enters and later leaves, it loses the $200,000. So entering pays only once Valdo has earned at least $200,000 of supernormal profit. The larger the sunk costs, the longer an entrant must stay to earn them back. If that takes years, the entrant cannot hit and run: it would have to stay and compete. So the threat is not believable, and a single firm can keep its price well above average cost.
An incumbent, a firm already in the market, can use this on purpose, by raising the sunk costs an entrant faces. Heavy advertising may force an entrant to advertise heavily too, to attract buyers, and that advertising is a sunk cost. Exclusive contracts tie suppliers or buyers to the incumbent, so an entrant must pay to attract them, money it loses if it leaves. If Zenko Air advertised heavily, Valdo's sunk cost of entering would rise above $200,000.
Exam Matters: When you discuss sunk costs, split the entrant's costs into the part it could get back and the part it could not, using the case. Then judge how believable hit-and-run entry is.
Allocative efficiency means producing the goods buyers want, in the quantities they want: no more and no fewer.
A firm is productively efficient when it makes its output at the lowest average cost it can reach.