Market Structures and
Economic Efficiency
A2 Micro

Google and Apple’s RevenueWhat is Economic Efficiency?
• Efficiency is about a society
making optimal use of scarce
resources to help satisfy
changing wants & needs
• There are several meanings of
efficiency but they all link to
how well a market system
allocates our scarce resources to
satisfy consumers
• Normally the market mechanism
is good at allocating these
inputs, but there are occasions
when the market can fail
How well are our scarce resources used? This is what is discussed
when economists talk about and analyse economic efficiency
Allocative Productive
Dynamic Social

Google and Apple’s RevenueBasics of Dynamic Efficiency
Innovation is putting a new idea or approach into action. Innovation
is 'the commercially successful exploitation of ideas'
• Product innovation
• Small-scale and frequent subtle
changes to the characteristics
and performance of a good or a
service
• Process innovation
• Changes to the way in which
production takes place or is
organised
• Changes in business models and
pricing strategies
• Innovation has demand and supply-
side effects in markets and the
economy as a whole
Austrian economist
Joseph Schumpeter
(pictured) coined the
term creative
destruction which
refers to the
upheaval of the
established order in
the pursuit of
innovation.
Smaller disruptive
businesses often
challenge existing
firms with market
power!

Duopoly – US Energy Drinks Market (2015)
41%
38.9%
8.8%
3.8%
2.6%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
Red Bull North
America
Monster
Beverage
Corporation
Rockstar Inc. Monster
Beverage Corp.
PepsiCo Inc.
Marketshare

Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S1
AC
MC
P1
AR1=MR1
The Entry of New Firms in the Long Run
At this market price P1, most firms in the market make supernormal profit

Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S1
AC
MC
P1
AR1=MR1
S2
P2
The Entry of New Firms in the Long Run
The entry of firms causes an outward shift of market supply – price falls

Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S1
AC
MC
P1
AR1=MR1
S2
P2
The Entry of New Firms in the Long Run

Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S1
AC
MC
P1
AR1=MR1
S2
P2
AR2=MR2
The Entry of New Firms in the Long Run

Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S1
AC
MC
P1
AR1=MR1
S2
P2
AR2=MR2
Q2
Long Run Equilibrium Price and Profit
In long run equilibrium all firms are making normal profits (P=AC)

Econ Efficiency & Perfect Competition
• Allocative efficiency: In both the short and long run, price is
equal to marginal cost (P=MC) and thus allocative efficiency
is achieved. No one can be made better off without making
some other agent at least as worse off – i.e. we achieve a
Pareto optimum allocation of resources.
• Productive efficiency: Productive efficiency occurs when the
equilibrium output is supplied at minimum average cost. This
is attained in the long run for a competitive market.
• Dynamic efficiency: We assume that a perfectly competitive
market produces homogeneous products – in other words,
there is little scope for innovation designed purely to make
products differentiated from each other and allow a supplier
to establish some monopoly power.

Examples of Monopolistic Competition
Shoe repairs and
key makers
Taxi and minibus
companies
Sandwich bars
and coffee stores
Hairdressing
salons
Dry-cleaners and
launderettes
Bars and
Nightclubs

(1) Short Run Price, Output and Profit
MC
Price
and
Cost
Output
AC
MR1
AR1
P1
Q1
C1

(2) Long Run Price, Output and Profit
MC
Price
and
Cost
Output
AC
MR2
AR2
P2
Q2

Monopolistic Competition & Efficiency
1. Prices are above marginal cost – meaning that the
equilibrium is not allocatively efficient
2. Saturation of the market may lead to businesses being
unable to exploit fully economies of scale - causing
average cost to be higher – therefore not productively
efficient
3. Critics of heavy spending on marketing and advertising
argue that much of this spending is wasteful and an
inefficient use of scarce resources.
4. Debate over the social costs of packaging and negative
externalities is linked to monopolistic competition
5. Monopolistic competition associated with extensive
consumer choice and innovation – good for dynamic
efficiency

Cost & Price
Output (Q)
Perfectly Competitive Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
AC
MC
P1 P1
Q1
S2
Economic Case Against Monopoly

Cost & Price
Output (Q)
Cost & Price
Output (Q)
Perfectly Competitive Market Pure Monopoly Market
S1
D1
P1
P2
Entry of
new firms
drives
price
lower
AC
MC
AC
MC
Monopoly
demand
(AR)MR
P1 P1
Q1 Q2
P2
C2
Monopoly
Profit
S2
Monopoly power usually results in higher prices + lower output
Economic Case Against Monopoly

X-Inefficiency in Imperfect Competition
Price
and
Cost
Output
AC
Productive efficiency is when a
firm is operating at the lowest
point of their average cost curve

X-Inefficiency in Imperfect Competition
Price
and
Cost
Output
AC
Productive efficiency is when a
firm is operating at the lowest
point of their average cost curve
X-inefficiency means that the
average cost of production is
higher than on the AC boundary

Google’s Dominance in Europe

Amazon’s Dominance in Cloud Services

Some Contestable Markets In Action
Peer to Peer
Lending
Fast Food
Industry
Hotel / Room
Sharing Sector
City Transport
Services
Private
Education
Bookselling

Monopoly versus Contestable Markets
Characteristic / Issue Monopoly Contestable Market
Number of firms
Natural / Working / Dominant
Monopoly
Any number possible – usually
many
Barriers to entry High – entry and exit costs
Low – absence of sunk costs
makes market contestable
Supernormal profit High in short and long run
Threat of entry limits profits – risk
of hit and run entry
Pricing power
Pricing power is important –
may be limited by regulation
Actual and potential competition
affects pricing
Economic efficiency
Low allocative (price >MC)
Productive – econ of scale
Dynamic – use of profits
Contestability should help move
the market closer to efficient
outcomes
Innovative behaviour Potentially strong
Likely to be strong – e.g.
disruptive technologies

Market share of mobile handset manufacturers in the UK in June 2014
31.8%
22.9%
16.9%
6.7% 6.1%
3.7%
2.4% 2.1%
7.4%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Samsung Apple Nokia Sony HTC RIM Motorola LG Other
MarketshareA Contestable Oligopoly