Microeconomics - Types of Markets - Research Paper Example

Microeconomics - Types of Markets Microeconomics is the study by individuals on allocating scarce resources in a market (Sloman, 1999). There are four basic types of market structures which are as follows: 1) Perfect Competition: Perfect competition exists when there are homogenous products and many buyers and sellers. The competition is much tensed and everyone is fighting the rat race of winning over the other. There are a large number of firms producing the same kind of products or services such as wheat, financial securities, or copper. No single buyer or seller has the power to influence the market price. The seller cannot change it according to his will because for instance he increases the price creating a sense of superior image to his brand, the others will benefit because of the similarity in the uniform commodity trading. Certain features of perfect competition: (Pettinger, 2008) 1) Many firms producing the same good 2) Freedom of entry and exit 3) Homogenous products produced 4) The demand curve is price elastic 5) Sellers and buyers both have perfect information In the long run, the firms are ought to make a normal profit and the market price is determined by the forces of demand and supply. However, an important point to note is the situation in the long rum equilibrium. If demand increases to a great extent, price will rise. Therefore, the demand curve will shift upwards causing firms to make supernormal profits. More firms would join the industry and hence, price will fall again settling at the equilibrium rate. Also, if the average costs are greater than the average revenue then most firms would go out of business. Once the supply curve falls, prices tend to rise. Perfect competition means there should be no imperfections in the market which may arise due to lack of knowledge or immobility of resources. Nonetheless, these factors are unrealistic in this world. One of the important reasons why perfect competition does not exist in the real world is the economies of scale. In most of the industries, a firm has to be quite large to experience economies of scale. But in perfect competition, firms have an insignificant market share and are too small to achieve economies of scale. Once a firm expands and achieves economies of scale, it would lower it costs and gain market power. The firm can reduce the prices and drive out the smaller firms from the industry. Hence a perfect competition can only survive in an industry where there are no economies of scale. Although the perfectly competitive market model is not applicable to the real world setting, it plays a significant role in economic analysis and policy. The model can be used as a criterion to judge the deficiencies of the real world industries and can help government to articulate policies towards the betterment of the industry. 2) Monopoly: A single industry that produces a product is called a monopoly. This is not it, however, no close substitutes are present and barriers to enter and exit in the market are high. Such barriers include patents, heavy investments, copyrights or achieving economics of scale comparable to the monopoly. It is easy for a large firm to drive out infant industries with their low costs and flanking marketing strategies. A monopoly is said to exist if it owns more than 25% of the market share. A monopoly may result due to government regulations. These type of monopolies are called natural monopolies. The other type is the non regulated monopoly where it is up to the company to set the price that the market will bear. An example is of Microsoft, which is a market leader in providing operating systems to millions of people around the world. Features of a Monopoly: 1) Single producer of the good or service 2) Price maker 3) Legal and natural barriers to entry 4) No close substitute of the product or service A natural monopoly enjoys considerable economies of scale. It also enjoys the benefit of cost leadership and dominates the industry. A natural monopoly enjoys natural barriers to entry may be due to an efficient workforce, low cost of resources, established market image or a unique offering. A discriminating monopoly gains by supplying to two different groups of consumers. The elasticity of demand which is the change of quantity demanded as compared to change in price is different for both the groups of customers. An example could be business travelers who are generally less sensitive to changes in prices of air fares as compared to tourists or students. The air company can target business customers by charging them higher fares than any other customers. Such discrimination can only occur on goods that cannot be sold again, for example a movie ticket. Moving on, monopolies are formed in certain ways. Horizontal integration is when two firms at the same stage of production merge. Through vertical integration where a firm controls production processes by either integrating backwards or forward. Backwards integration means controlling the initial stages of production whereas the latter means controlling the ending production processes. Or a firm can just expand on its own by opening up branches at various places or be the first one to come up with an innovative patented idea. A monopoly can be troublesome for many developing countries. Monopolies usually try to outsource their manufacturing processes to low cost countries and exploit the labor there. With promises of constructing infrastructure, improvising on technical abilities, enhancement of foreign exchange reserves and renewing equipment, the disadvantageous may outweigh such benefits. Environmental destruction, low wages to workers, depletion of natural resources and lack of construction can be heavy for developing countries. Monopolies on their own are known to suffer from ‘X-inefficiency’. It is argued that monopolies don’t produce on the least average cost as they have no incentive of cutting costs due to lack of competition. Also, monopolies are also known to exert their power on suppliers and give them lower prices. With the advantage of economies of scale, the sheer size of a company can endure high average costs at some point leading to diseconomies of scale. To conclude, breaking monopoly power is often difficult by governments. Monopoly power is not necessarily always dreadful; it can be regulated by governments and at the same time they can enjoy their superiority over products and services. 3) Oligopoly: An oligopoly exists when a five firm concentration ratio is more than 50%. Firms are dependent on each other in terms of price setting. Certain barriers to entry exist, but less than a monopoly. Firms produce differentiated products and advertising is an essential tool in winning over each other. An oligopoly is considered to be the most common market structure used in today’s world. An example of an oligopoly is the cement industry where a few large firms dominate the market and fully compete on their different quality cements. Price differences are rare and thought over smartly. Oligopolies are based on a Kinked demand theory. The following figure shows the demand curve of an oligopoly: Where, MC = Marginal cost AR = Average Revenue MR = Marginal Revenue All firms seek to maximize profits but if they increase the price they become uncompetitive. If firm A increases the price of its product from P1, other firms will not follow the price change. Hence, the demand for Firm A’s product will fall as consumers will buy the product from other competitive firms at the price P1. This will lead to fall in revenue of Firm A. If firm A lowers the price of its product from P1, they will gain a huge increase in market share. However, other firms in the competition will also follow the price decrease to maintain their market share. Consequently, the revenue of firm A will not increase but rather will decrease. Hence the prices will be inflexible in oligopoly and this kinked demand curve shows that a variation in marginal cost still gives the same price. The change in price leads to the loss of revenue for the firm and hence firms in oligopoly keep their prices stable. Firms try to differentiate themselves by focusing on the customer and increasing levels of satisfaction. High levels of promotions and artificially created barriers to entry increase the likelihood of a company. However, one firm that is usually domineering in size sets the price and others follow. Long ago, General Motors was the price leader in the automobile industry until foreign competition drove it into a monopolistic competition. Many tobacco and airline companies can be categorized as oligopolies (Hobday, 1999). Features of an Oligopoly: 1) Products can be homogenous or differentiated 2) Barriers to entry but less than a monopoly 3) High levels of promotion to differentiate its product or service 4) Exists when 5 firm concentration is around 50% 5) Kinked demand theory 6) Price leadership theory 4) Monopolistic competition: A monopolistic competition exists when there are heterogeneous products and many buyers and sellers. Entry in this structure is relatively easy and most common examples include restaurants and retail stores. This structure is a form of imperfect competition where firms can behave like monopolies in the short run using their market power to generate profits. However, as other firms enter the market, the benefits of differentiation dwindle with increase in competition and a firm becomes a perfectively competitive firm. The long run characteristics are that of a perfectively competitive firm and the only difference is that monopolistic competition produces differentiated products with non price competition. The demand curve is also downward sloping unlike a perfectively competitive firms perfectly elastic demand schedule. Goods in this structure have imperfect substitutes and will have differences in quality, size, appearance, image so on, and so forth. Companies differentiate using advertising including television, radio, billboards etc. this makes demand less elastic and obstructs competition (Lipsey, & Chrystal, 2001). The firm will have some market power and can raise prices without the fear of losing all its customers. Features of monopolistic competition: 1) Many firms 2) Product differentiation 3) Easy entry 4) Independent decision making 5) Market power References Sloman, J. (1999). Economics. U.K, London: Prentice Hall. Pettinger, T. (2008, may 16). Economics help. Retrieved from http://www.economicshelp.org/index.html Hobday, I. (1999). Economics- a first course. U.K, London: Hodder and Stoughton. Lipsey, R., & Chrystal, A. (2001). Economics. U.K, Oxford: Oxford University Press. Read More