3.3.3 - Market structures and contestability

Competition can strengthen cost and allocative discipline; market power can weaken it but may finance scale and innovation. Judge actual incentives, entry threats and regulation rather than the market label alone.

Rank firms by the same market-share measure, select the largest $n$, add their percentage shares and include the % unit. If data are sales values, calculate each share against total market sales first.

If the four largest shares are 24%, 18%, 13% and 9%, $CR_4=24+18+13+9=64\%$. A fall from 72% to 67% is a 5 percentage-point fall, not a 5% fall.

A high n-firm concentration ratio shows that a small group controls a large share of the defined market, suggesting oligopoly and possible market power. A low ratio suggests a more fragmented market.

Each firm chooses output where $MC=MR=P$ with MC rising. In the short run, price may lie above, equal to or below AC, creating supernormal profit, normal profit or loss.

Supernormal profit attracts entry, shifting market supply right and lowering price; loss causes exit, shifting supply left and raising price. With unchanged costs, entry/exit continues until firms earn normal profit where $P=AR=MR=MC=AC$.

A firm's output can fall as entry raises total industry output. The long-run result depends on free entry/exit and no permanent cost advantage.

At a short-run competitive equilibrium, a producing firm chooses the rising part of $MC=P$, so the last unit's marginal benefit equals marginal cost and allocative efficiency is achieved under the model assumptions. The firm need not produce at minimum AC, so productive efficiency is not guaranteed.

Entry after supernormal profit and exit after loss change market supply and price. With unchanged costs and free entry and exit, adjustment ends at $P=MC$ and minimum $AC$: allocative and productive efficiency coincide with normal profit.

Successful differentiation makes substitutes less close, shifts demand right and can reduce price elasticity, allowing a higher price or market share. It also has development and promotion costs.

The firm maximises profit at $MC=MR$ and reads price from its downward-sloping AR curve. It can earn supernormal profit, normal profit or loss in the short run.

Supernormal profit attracts differentiated rivals, reducing each incumbent's demand until AR becomes tangent to AC at the profit-maximising output. The firm then earns normal profit in long-run equilibrium.

Short-run loss causes firms to exit; remaining firms gain demand until normal profit is restored, assuming free entry/exit and unchanged conditions.

The static inefficiency may be offset partly by greater product variety and choice, which standard $P=MC$ comparisons do not fully capture.

A two-firm/two-outcome payoff matrix shows that each firm's best action depends on its rival. Both may gain from maintaining high prices, yet each can have an incentive to cut price secretly, creating a prisoner's-dilemma outcome.

Collusion is more stable with few firms, repeated contact, transparent prices and credible punishment; it weakens with cheating incentives, demand shocks, new entry and legal penalties.

Price fixing typically moves price above competitive levels and restricts output, transferring surplus to producers and creating deadweight loss.

Consumers may gain lower prices temporarily, while firm margins, supplier payments and employment can fall. Predation and limit pricing work only if the incumbent can sustain the strategy and entry remains deterred later.

These methods aim to shift demand right or make it less price elastic, increasing sales or pricing power without cutting price.

Price competition is attractive when costs can sustain cuts; non-price competition is stronger when differentiation creates lasting value. Outcomes depend on pass-through, quality truthfulness and market power.

Scale economies/natural-monopoly cost conditions, patents, licences, control of essential inputs, network effects, branding, strategic pricing and capital requirements can protect monopoly power.

Specialised infrastructure, contractual obligations and sunk advertising/R&D make exit costly, reducing hit-and-run entry because entrants risk unrecoverable loss.

Stronger barriers make demand less contestable and allow supernormal profit to persist; innovation, regulation or technological change can weaken them.

A monopoly chooses output where $MR=MC$ with MC rising, then reads the highest price consumers will pay from the AR/demand curve at that output.

Compare price/AR with AC: supernormal profit per unit is $P-AC$, so total supernormal profit is $(P-AC) imes Q$. High barriers can sustain it in the long run.

Because the monopoly faces downward-sloping demand, MR lies below AR: selling more usually requires a lower price, including on earlier units.

Consumers benefit only when cost savings, investment or service obligations are delivered and passed through. Regulation, ownership, objectives and contestability determine the balance.

A natural monopoly exists when economies of scale are so extensive relative to market demand that one firm can supply the whole market at lower average cost than two or more firms.

Large fixed infrastructure and low marginal cost make LRAC fall across relevant demand. One network avoids costly duplication, but an unregulated provider may restrict output and charge above cost.

Profit-maximising discrimination sets higher price in the submarket with less elastic demand and lower price where demand is more elastic, subject to marginal conditions.

A pure monopsony has one buyer; monopsony power exists when a buyer can push input price or wage below the competitive level.

In a labour monopsony, the buyer hires where marginal labour cost equals labour demand and pays the wage on labour supply, typically giving lower wage and employment than competition.

Contestability concerns the threat of potential competition, not the current number of firms. Even a concentrated market can behave competitively if entry is credible.

If supernormal profit or a high price attracts rapid entry, incumbents may use limit pricing, control cost, improve quality and innovate to keep entrants out.

The credible threat reduces the ability to sustain supernormal profit even when no entrant is currently present. Firms may accept normal or lower profit to protect long-run market share.

This discipline is stronger when entrants can reach scale quickly, consumers can switch and sunk costs are low; branding, capacity constraints or retaliation weaken it.

Benefits depend on entry being credible and sustainable, not merely legally permitted. Excessively easy hit-and-run entry can weaken investment in fixed networks or quality.

A sunk cost is an expenditure that cannot be recovered on exit, such as market-specific advertising, specialised research or non-redeployable equipment.

A potential entrant compares expected profit with the risk of losing sunk investment. Larger sunk costs make entry and hit-and-run exit riskier, so incumbents can sustain higher prices/profits with less threat.