The Effect of International Trade and Role of the Government in Price Setting in Market Structures - Coursework Example

Market Structures

Introduction

In order to differentiate the markets in terms of number of firms, ease of entry and exit, similarity of products/services sold on the markets there was developed a system of classifying the market structures (Tucker, 2008). There are identified several key types of market structures, including: perfect competition, monopolistic competition, oligopoly and monopoly. Below is provided a more detailed discussion of each of the above mentioned market structures. Discussion of each type of market structure will be further supported with analysis of key characteristics of market structures, the role of entry/exit barriers, price elasticity of demand, role of government and effect of international trade on market structures.

Perfect competition

Perfect competition, also known as pure competition, is a market structure characterised by a homogeneous product, large number of small firms, and low entry and exit barriers (Tucker, 2008). In a purely competitive market, all firms produce a homogeneous or standardized product/service, which have identical characteristics. Furthermore, the theory of perfect competition implies that there are many small firms selling similar product. The small sizes of firms do not allow sellers to affect the price for specific product and therefore, no single firm is able to influence the market price (Tucker, 2008). Finally, in a perfectly competitive market, new firms face with no or low barriers to enter and exit the industry. It means that practically anyone can try himself in this business, if they have access to basic resources required. While in theory, this type of market structure is well-developed and seems to be very attractive for most market players, in practice, the concept of perfect competition is “logically impossible” (McDermott 2015, 688). Even though the concept of perfect competition is often employed in the works of economists, its self-contradictory concept is unacceptable in practical life. Still, some actual markets such as farm products or stock markets do approximate the model of perfect competition quite closely (Tucker, 2008).

Monopolistic competition

Monopolistic competition is a market structure that has many small firms offering a differentiated product or service. Similar to the perfect competition, firms enjoy low or no entry and exit barriers. The main characteristics of this market structure is product differentiation. Firms are actively involved in the process of creating differences among the products available on the market (Trucker, 2008). Under monopolistic competition, firms tend to compete on non-price competition including: packaging, product quality, customer service, advertising and marketing, product innovation, location, etc. The demand curve under monopolistic competition is less elastic than pure competition due to the seller’s efforts to differentiate the product from competitors (Trucker, 2008). Furthermore, a monopolistically competitive firm will not be economically profitable in the long run. Low entry barriers will attract new players and demand curve of the firm will decrease. The firm will increase its marketing/advertising budget to differentiate itself from its rivals, but in the long run it will earn zero economic profit (Trucker, 2008).

The oligopoly market structure

Oligopoly is defined as an imperfectly competitive market structure, characterised by a domination of few large firms selling either homogenous or differentiated product. This type of market structure implies high barriers to enter and/or exit the industry and thus imposes a limitation on the number of market players (Trucker, 2008). However, it is interesting to note, that in contrast to monopolistic and perfect competition, firms operating under oligopolistic market structure may offer either identical or differentiated product.

The oligopolistic market structure is especially common in the industries such as aircraft, steel, aluminium, tobacco, automobiles, drugs, etc. The competition is limited due to a limited number of market players who have access to required resources, assets and capital. Quite often, oligopolistic competition is referred to “Big Four” or “Big Three” as very few firms dominate the industry or sector. The decisions about product and price adjustments under oligopolistic market structure are more complex compared to perfect and monopolistic competition (Trucker, 2008). All big players are mutually interdependent on each other due to large market shares they retain.

As it already has been mentioned, oligopoly is a market structure characterised by high entry barriers. Industry/country specific legal restrictions, control over strategic natural resources, exclusive financial requirements, large initial capital investment, patent rights, R&D capabilities are some of the key entry barriers faced by the firms. Only limited number of firms have resources and capabilities to overcome these barriers and to achieve the economies of scale (Trucker, 2008).

To illustrate example of oligopoly it is possible to refer to Apple iOS. The company offers a unique operating system to its customers that enable to support the infrastructure of all Apple products. The only competitor is Google Android, which offers alternative to Apple iOS. The operating system industry for smartphones is dominated by these two oligopolist players. On the one hand, two firms-developers of operating systems dominate the market. On the other hand, the threat of entry of new players is extremely low due to high barriers. Other firms are less likely to have sufficient capital, R&D capabilities, reputation, and economies of scales required for competing with Apple iOS or Android.

The monopoly market structure

Monopoly as a market structure, whereas a final consumer has a limited choice due to restricted competition on the market. Monopolistic market is characterised by a unique product/service, single seller, and impossible entry into the market (Trucker, 2008). Under monopolistic market structure there is only single seller in the industry who offers a unique product to the consumers. While it is difficult to find a pure monopolist in national and international scales, at local level single firms may represent local monopolists. Thus, for example, the only electricity power supplier or gas station located in a small village or city may be a monopolist on the market. To be a monopolist the firm should offer unique product/service with no close substitute(s). Moreover, there is another important characteristics of monopolistic market structure – extremely high entry barriers. When there are high entry barriers other firms just cannot enter an industry to make up competition to the single player. These barriers normally will be posed at the government level through various restrictions and legal regulations.

The influence of high entry barriers into a long-run profitability of the firms

High entry barriers have direct impact on the long-run profitability of the firms, especially those operating under monopolistic and oligopolistic market structures. Under both oligopoly and monopoly the entry barriers are often high, which means that these firms can earn profits in long-term perspective being “protected” from other entrants. Furthermore, high entry barriers imply that the probability that new entrants will be able to gain significant market share also is limited as they are more likely to lack required economies of scales, reputation and brand recognition, etc.

The competitive pressures that are present in markets with high barriers to entry

Markets with high barriers to entry imply that the market competition in terms of the number of players is comparatively limited and is more likely dominated by few key players. Such barriers as level of capital investment, economies of scale, switching costs, innovation capacity, brand image/reputation and absolute cost advantages are some of the most common barriers that prevent entry of new players. High barriers to entry imply that limited number of competitors will be accompanied with higher profitability. However, the competition is still very intensive in the industry with high barriers as firms are more likely to compete for their market position. Rivalry among the existing competitors will be associated with such competitive tactics as: price pressures, product introductions, advertising and marketing battles, increased focus on customer service, etc. (Porter, 1980). If demand growth remains to be slow, scope for differentiation is limited, fixed costs are high, switching costs are low, competitors are of relatively similar size with similar competitive capabilities, the rivalry will be stronger (Thompson et al., 2008).

The price elasticity of demand in each market structure and its effect on pricing of its products in each market

The demand curve in perfect competition is perfectly elastic as firms are free to sell any quantity or amount of output at the prevailing price (Jain and Ohri, 2010). However, the firm still has a choice to decide the volume of the output to be sold at the market price. Thus, the firm operating under perfect competition is price taker who still has capacity to adjust the quantity of products sold (Jain and Ohri, 2010). The demand in oligopolistic market structure depends on the pricing behaviour of the key competitors. As it has been mentioned, under oligopoly firms are interdependent on each other and decision to higher or lower the price will impact all market players. Thus, the demand will be driven greatly by such factors as number, prices and quality of substitutes (Gwartney et al., 2014). However, it is also worth to mention that oligopolistic firms may collude and raise the prices in order to take full control over price setting and output. The demand curve under monopolistic competition is similar to monopoly, whereas demand curve faced by a firm goes downward (Mukherjiee, 2002). As the firms are able to differentiate their products from others, they act as producers/providers of specific unique product and therefore they are price makers (Mukherjiee, 2002). The demand under monopolistic competition is more elastic compared to the demand under monopoly as there are many close-substitutes.

The role of the government in price setting in each market structures

Usually, the government plays an important role in creating and sustaining favourable business environment. Under perfect competition, the pricing of the product is driven mainly by demand and supply factors, whereas the sellers have no influence on the price setting process. The price is determined by the industry rather than by government or individual sellers. However, in other cases the government may introduce policies that would address the issues arising from high barriers to entry. Thus, for example, the government might impose or relieve restrictions on the number of rival firms in the industry, reduce artificial barriers that reduce/control competitors’ inflow, initiate government based production, or to regulate the price and output of firms in the market.

The effect of international trade on each market structure

Under perfect competition, international trade should produce significant economic gains as imported goods are purchased at lower prices while the exported goods are sold practically for the same price. Oligopoly as the market structure also gains from the international trade, however, the economic gains are comparatively lower that under perfect competition (Ruffin, 2002). International trade has a direct impact on the monopolistic competition, whereas firms are free to differentiate their products from the competitors. In this case, local firms with more fierce competition, while the customers benefit from greater choice and assortment. In oligopolistic market structure, international trade also will more likely have some negative effect, as the local firms will have to compete with foreign players based not only on the price but also on non-price characteristics.

Conclusion

There have been discussed four types of market structures: perfect competition, monopolistic competition, oligopoly and monopoly. All these market structures have different characteristics and features. While the market structures of perfect competition are less likely to occur in real life, the markets of monopolistic competition and olipgopoly are quite common. The research also indicates that high entry barriers on the market play an important role in firm’s long-term profitability and competitive positioning. Government as a policy maker might develop alternative strategies to remove or reduce these barriers.