Economic Terms

Is a Bank of England committee that is responsible for agreeing monetary policy in the UK. It includes 8 members including the Governor of the Bank of England. Each member has one vote. The committee is often abbreviated to the MPC.

The structure and organisation of the MPC is shown below.

 

Is a system of coins, notes and records that facilitates economic activity by providing a unit of account, a medium of exchange and a store of value.

Organise the provision of short-term debt to individuals, firms, banks, the government and other financial institutions. Term of debt typically varies from 24 hours to 12 months, highly liquid and can be bought and sold in any size denomination. Some of the most commonly traded instruments include government bonds and Certificates of Deposit.

The supply of monetary assets available in an economy at any point in time. It includes coins and notes and deposits held by banks. Due to modern advances most of the money supply is accounted for by deposits at banks.

The wage rate without adjustment for inflation.

Is a market structure that contains a large number of firms selling differentiated versions of a product. As all firms sell differentiated versions of the product being sold, this market structure combines elements from a monopoly and a perfectly competitive market and is therefore classed as a form of imperfect competition. 

The main assumptions that are required for a market to be classed as monopolistically competitive are as follows:

1. Large number of buyers (consumers) and sellers (firms) - this ensures that a large number of substitutes for the good are being produced. 
2. Perfect Information - consumers have the ability to assess each product and carry out price comparisons between rival firms. 
3. No barriers to entry or exit - any firm can enter the market to enjoy profits as there are no barriers of entry present. However, firms can also freely leave the market costlessly if they are making a loss due to no barriers to exit being present. It is this assumption of freedom of entry and exit which means that firms in this type of market structure will always make normal profits in the long-run. 
4. Firms produce differentiated products - this means that firms can effectively become price makers of their own version of the product, especially if the degree of product differentiation is significant.

If firms operate in a market where all of these conditions are met, it creates an environment of monopolistic competition. This type of market structure is often the most useful from a practical point of view as there are many examples of high-street shops that compete in this way. For instance, the fast food market is an example of a cluster of firms that compete in this way. This is because all firms offer a similar convenient cheap service but offer subtle differences in their service, in order to attract different types of customers, such as: providing different items on the menu, branding and advertising their products in a unique way and designing and planning the interior of their restaurants differently.

Product differentiation is the key feature of this market, as by doing so allows firms to compete for consumers in terms of the quality and individuality of their product rather than just on price. The main aspects of product differentiation available to firms are:

• Branding
• Packaging
• Quality
• Customer Service
• Extra Features
• Skill and Efficiency of Staff

The fact that these firms  differentiate their products slightly means that brand loyalty is created amongst their consumers and therefore they face a downward sloping demand curve (AR) rather than the perfectly elastic demand curve under perfect competition. This means that firms can charge higher prices without losing all of their customers - unlike in the perfectly competitive case. But as they still face some close competition from other firms, the demand curve is not equal to the market demand curve, like in the case of a monopoly. The downward sloping demand curve means that if firms wish to sell a higher quantity of the good then they must charge a lower price to do so.

As usual, firms in the market profit maximise where MR=MC and due to the fact that they have some market power as a result of product differentiation, the price that they charge is represented by the price they can set according to the demand curve for that specific quantity of goods. As this price is predominantly above the average cost of production, firms can make supernormal profits. However, it is important to note that supernormal profits are not always achieved n the short-run, as the ability to make profit in the shot-run depends on the position of the firm's average cost curve. This means firms can also make normal profit or economic losses in the short-run as well. The three possible short-run outcomes for firms is shown below:

However, these outcomes only theoretically hold in the short-run as a result of the assumption of no barriers to entry or exit in the market.

In the case of supernormal profits being made in the short-run, this is eliminated in the long-run because firms outside of the market are incentivised to join and produce because of the attraction of jointly earning supernormal profits. However, as there are only a limited amount of customers in the market, the greater the number of firms in the market, the more diluted the customer base for each incumbent firm becomes. This as a result causes the demand curve and marginal revenue curves to shift inwards, until only normal profits are earned by all firms in the market in the long-run.

The opposite process occurs if firms are making economic losses in the short-run.

When it comes to evaluating monopolistic competition, it is all about assessing the efficiency implications of the market structure and do that we can use the theoretical benchmark of perfect competition. 

First of all, productive efficiency is not achieved under this type of market structure as firms do not produce at the minimum of the average cost curve. This is the case in both the short-run and long-run as firms produce at a higher cost when maximising profits. This leads to efficiency and welfare losses that are achieved under a perfectly competitive market structure. 

In terms of allocative efficiency, firms in this market structure do not produce where the price is equal to the marginal cost (P=MC). This is because the product differentiation has allowed them to become price makers and therefore can set a price above the marginal cost, to the point specified by the demand curve. This means that compared to a perfectly competitive market, an optimal allocation of resources is not met and as a result a dead weight loss triangle is created in the process. This means that total welfare is higher under perfect competition. 

In terms of assessing the market structure for dynamic efficiency and X-efficiency, it all depends on the extent of product differentiation in the market. This is because the degree of product differentiation determines the level and type of competition between firms.

If a product becomes highly differentiated from other products, it effectively becomes a new product on the market. This essentially means that firms have insulated them from any direct competition as there are no close substitutes available. By doing so,  the firm has transitioned into a new niche market of which they are the only real providers of this type of good. Doing so, means they start to develop the characteristics of a monopoly and can now engage in setting their own prices without having to take into account the reaction of rival firms, as consumers demonstrate brand loyalty towards this differentiated good and on that basis are willing to pay more for that particular brand. The welfare implications are such that when significant product differentiation takes place, a wide range of products are created for consumers to choose from, which creates more opportunities for them. However, the fact that it could create a specific niche market means that the market may suffer from some of the inefficiencies and welfare losses of a monopoly, which incidentally are more significant than when competing under monopolistic competition. This factor alone could erode away the extra benefits consumers gain from having a wider range of product lines available to them. 

On the other hand, if product differentiation is slight, then firms will still have to compete with lots of close substitutes in the market, as the differentiation is not significant enough to distance away from rival products. This encourages firms to have to engage in non-price competition, as price competition could lead to a price war. This though can create dynamic efficiency and X-efficiency as firms need to compete to provide the best product and service in order to convince consumers to buy their version of the product. This in itself, can help drive up the standards of all firms involved by encouraging product innovations (dynamic efficiency). However, this form of dynamic efficiency only occurs if firms use any supernormal profits made in the short-run to pay for research and development projects. Doing so may present firms with an opportunity to become more efficient over time and make supernormal profits in the long run as well.  

A market structure where there exists just one seller of a particular good. This market structure is the opposite of a perfectly competitive market.

The assumptions that are required for a monopoly to hold are as follows:

1. A single firm controls the output of the entire industry - this ensures that this firm is a price maker and sets the price that maximises their profits.
2. There are significant barriers to entry - the presence of these barriers ensures that the monopoly power of the firm is protected, as no other firm can enter the industry.

If a firm operates in an industry where these conditions are met it creates a monopoly market structure. However, a monopoly is more of a theoretical market structure as there are very few practical examples of one firm controlling an entire market (pure monopoly). Often the theory of a monopoly is important to assess the impact of one large firm dominating several small firms. 

Just like under monopolistic competition, the monopolist faces a downward sloping demand curve (AR) as they are the only seller in this particular market, rather than the perfectly elastic demand curve under perfect competition. However, in the case of the monopolist, this is also the market demand curve as this is the only firm supplying this type of product to the market. It is this unique feature in monopoly markets that grants the monopolist a large degree of monopoly power. The monopolist profit maximises at the point where MR=MC, but because of the significant monopoly power, the price that they charge is represented by the price they can set according to the demand curve for that specific quantity of goods. The monopolist can do this because the monopoly power makes them a price maker. Because of the fact that the AR curve is higher than the AC curve for the monopolist at this point, it creates the conditions for the monopolist to extract supernormal profits from the market. In the long-run the monopolist outcome is unchanged as the presence of significant barriers to entry prevent new competitors from joining the market and stealing the supernormal profits available.

 

It is important to consider that this outcome is all based on the assumption that there exists significant barriers to entry in the market for the situation of supernormal profits to hold in the long-run.

However, the level of supernormal profits a monopolist receives will be subject to changes in market conditions such as the level of demand for the good. For instance, monopolists are price makers and therefore set their own prices and the demand curve determines how much output will be sold on the market at that price. A monopolist does not have the ability to set both the price and quantity of output. If the demand curve shifts inwards or the average costs of production for a firm increase, then this will reduce the level of supernormal profits belonging to the monopolist. If market conditions go against that of a monopolist and causes the firm to make economic losses in the short-run, then in the long-run the firm will leave the market and as the firm is the only firm in the market, the market will cease to exist in the long-run. This means that monopolists have to adhere to the standard shut-down points of all other firms. 

An interesting analytical point to raise when talking about monopolies is the comparison against a perfectly competitive market structure. This is because a monopoly is at the opposite end of the market structure spectrum when compared to perfect competition. When compared to this market structure the market equilibrium is more inefficient and results in lower welfare than compared to a perfectly competitive market because of the fact that monopolists are price makers. The optimal output level for monopolists is below that of a perfectly competitive market, as they set a higher price to maximise profits. As a result, this means that producer surplus increases because of the higher price and consumer surplus decreases due to the higher price. However, as the loss of consumer surplus is larger than the gain in producer surplus, there is an overall dead weight loss triangle created. Under a perfectly competitive market, social welfare is maximised as a result of producing at the point of allocative efficiency. Therefore monopolists reduce the overall level of social welfare in the economy, which is often why they are perceived as bad for an industry.  

In terms of efficiency, monopolies are both allocatively and productively inefficient. It is productively inefficient because the monopolist does not produce at the minimum of the average cost curve. This is because the monopolist profit maximises and that production point corresponds to an average cost that is above the minimum, resulting in productive inefficiency. As for allocative efficiency, the monopolist has significant monopoly power, so it sets a price above the marginal cost and the allocative efficiency condition of P=MC is not met. 

However, the question over whether a monopoly leads to dynamic efficiency is uncertain. The answer to this question identifies whether a monopoly market structure is better or worse than perfect competition and this is the key evaluation point to mention regarding monopolies. The reason for the uncertainty, is it all depends on what type of industry the monopolist operates in (the scope and importance of innovation and invention in the market) and whether dynamic efficiency can be easily achieved and whether from the monopolists perspective it is rewarding to invest and innovate.

For instance, the monopolist may be more dynamically efficient than perfectly competitive markets, if the monopolist uses the supernormal profits made in the short and long-run to invest research and development projects. By doing so, this will encourage innovation and invention into the production process, create X-efficiencies and improve the productively efficient point for the firm. In terms of the impact on a modern developed economy, if sustained it will increase the productive capacity of the economy and may even encourage other firms to become more dynamically efficient. This is most likely to be the case in industries where innovation and invention is required to continue to yield profitable results for the monopolist i.e. technology driven industries such as the upcoming driver less car market.

However, there is a fear that monopolists may be encouraged reap the supernormal profits made and without the fear of new competition coming in, divert those profits as dividends to investors and shareholders, increasing the shareholder return on the company instead of investing in research and development projects. The monopolist can do this because of the presence of significant barriers to entry. If this is the case then the market becomes dynamically inefficient and the outcome is worse than perfect competition. This occurs in industries where the rewards for innovation and invention are minimal e.g. service providers such as barber shops.

Despite all these problems with a monopolist, there may well be an advantageous case for one firm to control the entire infrastructure of an industry, as some markets involve significant initial infrastructure costs which would be unnecessary to duplicate. Therefore, to avoid these costs it is beneficial for the market to become a monopoly. This allows the monopolist to take advantage of the large economies of scale present, than have lots of smaller firms inefficiently compete over the market, raising costs and prices in the process. This is an example of a natural monopoly.

The ability of a single firm to influence an entire market. In this type of market structure monopoly power allows the monopolist to restrict output and become price makers i.e. price above the marginal cost.

This is a type of market structure where just one dominant buyer exists and there are many sellers.

Most common form of monopsony is the sole buyer of labour with many workers supplying their labour at a given wage rate e.g. the government employing workers for public services. Below is a diagram to illustarte the market structure of a monopsony in the labour market. The most striking part of this diagram is the increasing marginal cost curve for labour that these types of firms face. This is because as the firm is only employer of labour in this market if they wish to hire additional workers they have to offer higher wages but not only do they have to pay the new employee the higher wage but all the other existing workers wages will need to be increased as well.

 

The ability of a large buyer to influence the market outcome in a monopsony market structure. For instance the government is a major buyer in industries like the NHS and therefore have control of the wages paid to all those workers as they face very little competition from other buyers.