Market Imperfections and Failures - Assignment Example

? Market Imperfections and Failures Contents Contents 2 Introduction 3 Competition Policy in United Kingdom 3 Objectives 4 Objectives Relating to Microeconomic Theories 5 Externalities in Competitive Markets 5 Asymmetric Information in Competitive Markets 7 Monopoly 8 Oligopoly, Strategic Thinking and Game Theory 13 Conclusion 16 Reference List 17 Introduction In the modern world, economic growth in a nation can be obtained with the benefits of international trade and competition. History has shown that nations like, U.K., have adopted the mixed economic system, thereby achieving substantial growth since Industrial Revolution. Economists believe that competition in the market maximizes the value of the net social welfare in country. Imperfect competition in the market generates asymmetric information and dampens the level of welfare in the society. Discriminations made by the monopolists in the market not only hamper the social utility, but also engages in misallocation of resources. Efficient allocation of productive resources helps to the economy to reach a Pareto optimal stage. However, in the real world, corruption and strategic business initiatives of certain firms in the industry have reduced the level of competition in the economies of most of the nations (BIS, 2013). Public authorities of the countries are now taking active initiatives to augment the level of market competition in the economies (CIA, 2013). The Competition Law or Policy adopted by a country helps to promote the level of market competition by imposing special rules and regulations on the anti-competitive practices conducted by the contemporary corporate firms. This paper would focus on the Competition Policy of U.K and would show how the objectives of the policies are related to the microeconomic theories of market. The learnt from this paper would help to analyze the negative impacts on an economy due to the lack of proper market competition (Hubbard, 2008). Competition Policy in United Kingdom The competition policies in U.K have been introduced to check the monopoly power of the companies in the country. It was analyzed by the government that excessive monopoly power could create market failures in U.K., thereby going against the interests of the public. In 1988, the Competition Act was introduced by the government of U.K. to protect the interests of the consumers in the country (Mankiw and Mark, 2006). The two main factors that were checked by this law were: Abuse of Market Power Collusive Behaviour The first competitive policy instruments in U.K were introduced about fifty years ago. The Department of Trade and Industry, The Director General of Fair Trade and the Competition Commission of the country had introduced their first competitive policy instruments (Woodford, 2001). Over time, subject to the external changes in the market, the terms and conditions of the policy have largely changed in U.K. Finally, in 1988, the Competition Act was again modified and adopted as the approach of ‘prohibition’ to prevent dominance in the marketplaces of U.K (Manne, 2012). Objectives The primary objectives of the Competition Policy in U.K were: 1. The Policy was the basis for the concepts of the Fair Trade Act 1973. Thus, one of its objectives was to serve the interests of the public (Assael, 2005). 2. The Policy aimed at providing guidance and constraints to the discretionary power of the ‘decision makers’ in the market. 3. It aimed to promote and maintain the market competition. 4. To assure that consumers received quality products at a good price. 5. To augment innovation and productive efficiency in the market. 6. Assure balanced distribution of employment and industry in U.K. 7. To enhance the competitive powers of the domestic companies of U.K. in order to easily compete with the foreign companies (OECD, 2002). Objectives Relating to Microeconomic Theories This context of the paper would highlight that the goals or the objects of the Competition Policy introduced by U.K. are based on the theories of microeconomics, which relates to the study of imperfect market structures. Externalities in Competitive Markets The profits and the losses made by a firm are often influenced by the externalities in the market. When the action of an agent outside the production system of a firm affects the profit or loss of the organization, then it is termed as an externality. Externality in business can either be positive or negative in nature. Positive externalities generate profit to a business firm, whereas on the other hand, the negative externalities generate loss (Ross, 1979). Figure 1: Externalities in Business (Source: Nechyba, 2011) As stated in the above diagram, a+b+c signify the consumer surplus in the market and d+e+f is the producer surplus in the economy. ‘g’, in the above diagram, is the deadweight loss created in the market due to the social marginal cost (negative externality). It can be analyzed that the rising extents of anti-competitive practices in the market have increased the deadweight loss in the economy of U.K. As the theory of economics states, the government of the country have introduced the Competition Policy to reduce the dead weight loss in the market. The objectives 1, 2 and 3 in the Competition Policy have helped to reduce the negative externalities of anti-trust practices of the country (W. G. Shepherd and J. M., Shepherd, 2003). Figure 2: Benefit of the Competition Policy (Source: Nechyba, 2011) As stated in the above diagram, the negative externalities created by the anti-trust practices of the firms would reduce with the benefits of Competition Policy. In the above diagram, h+i denote the surplus that can be created by the Competition Policy. Asymmetric Information in Competitive Markets Extensive practice of asymmetric information in the market would cause inefficient allocation of the scarce economic resources. It is believed by the analysts in the market that existing information equitability in the market can be reduced only with the benefits of direct appraisal or screening and contingent payments (Alexander, 2009). It is true that in the market of U.K., some corporate companies are on their way to become monopoly business giants. These companies reduce the level of competition in the industry, thereby negatively affecting the social welfare of the economy. Figure 3: Loss of Asymmetric Information (Source: Nechyba, 2011) The above diagram states the loss created by an information asymmetric market. The government of U.K. have adopted the Competition Policy to keep a check on the extensive powers of the monopolists in the market. The objectives 2 and 3, in the above context of the Competition Policy, focus on reducing the extent of information imperfectness in the market of U.K. (McEachern, 2012). For instance, in 2010, the government of U.K. had found that some workers of the Royal Bank of Scotland Group (RBS) (Professional Practices Coverage Team) had provided the confidential information about loan pricing to Barclay’s on the occasions of general and two specific loans. Barclay’s found that this was violation of the Competition Policy. The RBS group was fined for this reason and was made to pay a sum of ?33.6 million as penalty for the violation (Munoz and Patrick, 2010). Thus, the Competition Policy has tried to reduce the harmful impact of imperfect information in the market. It has taken active steps to reduce the level of anti-trust practices in the market. Monopoly Monopoly market structure is the one that does not entertain any type of competition in the industry. In this type of a market, the number of sellers is only one. On the other hand, the number of buyers in the industry is infinite here. The single seller in the monopoly market structure has the power to manipulate the price level of the goods and services (Baye and Scholten, 1994). Figure 5: AR and MR Curve of a Monopoly Producer AR, MR Price or Average Revenue Curve (P or AR) Marginal Revenue Curve (MR) Quantity (Source: Authors Creation) As shown in the above diagram, the monopolist in the market is the price maker. Thus, it faces a downward sloping price or average revenue curve. The marginal revenue curve of a monopoly seller in the market also has a negative slope. Figure 6: Price Discrimination (Source: Stole, 2003) A monopolist in the market can often discriminate among its clients on the basis of the price which it charges for the products or services. For example, a doctor is a monopolist in his services and therefore, he might charge the rich customers a higher fee and charge relatively lower from the poor patients. Figure 7: Natural Monopoly (Source: Tragakes, 2011) In U.K. or in any other economy, monopoly market structure with a single seller may not exist in general. However, in certain times, a seller might become a natural monopolist in the market and threaten the other potential entrants by producing goods at the lowest possible marginal cost. The monopolist can take this initiative with the help of economies of scale in production, which he can achieve by enjoying the entire share of market demand (Tucker, 2010). Figure 8: Loss Associated with Monopolist (Source: Mankiw and Mark, 2006) However, it is true that a severe deadweight loss is created by a monopolist in the market. As shown in the above diagram, the welfare maximizing competitive output is higher than the output of the monopolist in the market. At the same time, the monopolistic price is higher than the competitive market equilibrium price level. In the real world, monopolistic competitions among the firms are more common than the monopoly market structures. In this type of a competition, there are few sellers and many buyers in the market. The sellers are the price makers because they sell differentiated products (qualitative differences). The levels of competition among these firms are very high. The revenue, cost and profit curves of the monopoly and monopolistic firms are similar to each other. Deadweight loss is also created by these sellers in the market (Chass, n.d.). One such industry in U.K. is the pharmaceutical industry. GBM Healthcare Ltd and GlaxoSmithKline are the pharmaceutical companies in the country (U.K.) which exploit the interests of the consumers by setting extraordinary prices for the life saving drugs. The monopoly power of these companies has increased the cost of healthcare and treatment to a large extent. Medical treatment in U.K. and many other countries have turned out to be luxury service consumption (Castro, 2012). It has been seen in history that there were severe critical situations where the access to life saving drugs had been made scarce artificially by these companies through the policy of hoarding. For example, Brazil had not received AIDS medicines from GlaxoSmithKline at times of crisis. Thus, asymmetric information and monopolistic powers among the corporate firms are indeed harmful to the benefits of the consumers (Riley, 2012). The government of U.K., through the Competition Policy, have intended to reduce the power of the monopoly and monopolistic sellers in the market. The objectives 1, 2, 3 and 4 of the Competition Policy aim to reduce the powers of the monopolists in the market (Faranham, 2005). This Policy in U.K. economy investigates the mergers and acquisitions that take place between the companies. It is true that corporate companies often merge to jointly enjoy the benefits of a natural monopolist in the industry. The European Competition Authority constantly checks the powers of the companies that were privatized in 1990’s and 1980’s. Fresh ‘price capping’ and competition had been introduced in the telecommunications, gas and electricity industries in 1984. The government of U.K. is recently checking the powers of IMB and analyzing its business behaviour with the other competitors and suppliers in the industry. Imperial Tobacco and Gallaher, a tobacco company in U.K., was penalized by the office of Fair Trading for practicing ‘price fixation’ in the market (Riley, 2012). Oligopoly, Strategic Thinking and Game Theory The oligopoly market structure is a more complex type of monopolistic market. In this type of a market structure, the number of sellers in the industry lies within 8 to 10. However, the number of buyers in the market is infinite. In order to enjoy economies of scale in production and a substantial share of market demand, the sellers in an oligopoly market structure execute high level of market competition. This type of a market does not support competition and lead to inefficient allocation of resources (Richtel, 2000). The firms in an oligopoly market structure undertake their business decisions on the basis of strategic thinking. In this system, a single firm undertakes the decision about price and quantity by strategically assuming the price which can be established by the potential rivals in the industry. A single seller in an oligopoly market structure has the power to influence the market (Gravelle, and Rees, 2004). A firm responds to the choices of its rivals by taking in account that the rivals would also make their business decisions on the basis of that of the firm. In this type of a market, the seller’s relations exist between cooperation and self-interest (Hall, 2008). Figure 9: Oligopoly (Source: Faranham, 2005) The above graph shows the equilibrium conditions of an oligopoly firm. The demand curve faced by this type of a firm is kinked in nature. Game Theory A game theory is a model that helps to mathematically analyze the strategic options adopted by the firms in an oligopoly market structure, where the Dominant Strategy provides the best outcome for a seller (player). Figure 4: Game Theory Matrix (Source: Econ., 2013) The above diagram shows a typical (2x2) matrix that resolves the payoffs of two players (sellers) in an oligopoly market. There are various models of Oligopoly market structures. However, the collusion of the oligopoly firms creates maximum loss of welfare in the market. In U.K., the soft drinkers and the commercial banks exist in an oligopoly market structure. In the global economy, the footwear industry is an oligopoly market (Hammonds, 2006). This is because about 60% of the global demand for footwear is enjoyed by Nike Inc. and Adidas (Riley, 2012). The supermarket industry in U.K. is a typical example of oligopoly. Even at the time of global recession, the commercials made by these companies were high. The Competition policy of U.K. has checked the unfair resource allocation practices of these companies. For example, Asda had introduced a special price reduction campaign worth ? 1 billion in response to the Competition Policy (Pearsonblog, 2008). Thus, the above analysis clearly shows that the Competition Policy in U.K. has helped in augmenting economic development. Its objectives have tried to efficiently allocate the scarce resources in the economy by promoting more market competition. The Tree Trade Agreement has encouraged foreign investments in U.K. which has helped to make the domestic companies of the country more competitive in nature (Arnold, 2008). Conclusion Competition in the market is highly beneficial for the growth of social welfare. Equitable and efficient allocation of resources can never be achieved without the growth of social welfare. Economic development in a country can only be attained with the benefits of efficient and equitable allocation of these resources (Smith, 2010). However, in real world as shown in the above context, the market fails to be perfect and engages in many failures. This is the time when the government should play an active role. The socialistic principles of Competition Policy in U.K. are playing a pivotal role in the economic development of the country. The Competition Policy in U.K. has encouraged the public and monetary authorities of the country to make expansionary policies by which they can boost up the productivity in the economy. This has in turn helped to increase the employment opportunities in the nation (Boyes and Melvin, 2012). Reference List Alexander, C., 2009. Market Risk Analysis, Value at Risk Models. New Jersey: John Wiley & Sons. Arnold, R. A., 2008. Macroeconomics. Connecticut: Cengage Learning. Assael, H., 2005. Consumer Behavior A Strategic Approach(2005) Indian. Delhi: Dreamtech Press. Baye, M. and Scholten, P., 1994. 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