Microeconomics: Principles and Policy - Assignment Example

MICROECONOMICS: MARKET STRUCTURES Introduction Economics is a social science that studies human behavior in relation to limited resources to fulfillhuman wants. The science is divided into macroeconomics, the study of the economy as a whole, and microeconomics, which analyzes "the market behavior of individual consumers and firms in an attempt to understand the decision making process of firms and households (microeconomics, Investopedia). It focuses on demand and supply patterns and the determination of price and output in individual markets or industries. An analogy might make the distinction clearer: Microeconomics may be compared to the study of the forest, while microeconomics concerns the study of the trees. Microeconomics covers a rather broad area: demand and supply, indifference curve analysis, elasticity of supply and demand, production and cost, marginal analysis, market structure, pricing, and so on. This study will attempt to deal with the area of market structure which is very interesting because of its pervasiveness in our lives: Perfect competition, monopoly, monopolistic competition, and oligopoly. An understanding of market structure is essential not only for economists but also for individual businessmen and corporations, for it will help them greatly in dealing with numerous problems encountered in the competitive arena of business. The four major market structures often discussed by economists are perfect competition, which is production by numerous firms with identical/homogeneous products as well as the presence of conditions of free entry and exit; monopoly, which is production by a single firm; monopolistic competition, which is production by many firms with somewhat different or differentiated products; and oligopoly, which is production by several firms. Perfect Competition Perfect competition is the ideal market condition envisioned by the great economist Adam Smith, and is often studied first because it is the easiest to understand and it can serve as starting point as well as a gauge by which to measure the performance of the other market structures. The demand curve of a perfectly competitive firm is horizontal because its output is but a small part of total production and it cannot affect the price. The conditions for perfect competition are: a) a large number of small firms and customers, b) homogeneity of product, c) freedom of entry and exit, and d) perfect information about available products and their prices. Many farming and fishing industries closely approximate perfect competition. Monopoly. At the other end of the spectrum is the monopoly. A monopoly is a one-firm industry that produces a product for which there are no close substitutes. A pure monopoly is an industry in which there is only one supplier of a product or service for which there are no close substitutes and which it is very hard or impossible for another firm to coexist (Baumol and Linder 256). Examples are utility companies such as telephone or electricity providers and the post office. There are several reasons why a monopoly may persist and keep rivals out of he market. These are as follows: 1) Legal restrictions - given by statute or exclusive licensing by the government, 2) Patents - such as those enjoyed by drug firms for a period of 20 years; 3) Control of scarce raw materials or input - such as the diamond syndicate in South Africa; 4) Deliberately erected entry barriers - such as the threat of costly lawsuits against new entrants or the budgeting of heavy advertising expenditure that a new entrant cannot match, 5) Large sunk costs - such as the investment involved in establishing an aircraft manufacturing company such as Boeing; 6) Technical superiority such as that enjoyed by IBM years ago and by Microsoft more recently, and 7) Economies of scale which only large firms can achieve, thereby discouraging smaller entrants. A natural monopoly exists when only one firm can survive because of cost advantages. Because of the so-called economies of large-scale production, other firms are discouraged from trying to gain entry because the huge cost involved is a barrier. While a perfectly competitive firm is a price taker, the monopoly is a price maker because it can to a significant degree determine or dictate the price of a product or service. A monopoly can impose a high prices despite low costs created by economies of scale. However, its demand curve is downward sloping, hence the monopolist cannot absolutely select both price and quantity it sells because the higher the price it sets, the less it can sell. Nevertheless, the government may seek to regulate its price-setting that can generate the so-called monopoly profits, in the interest of public welfare. When monopolies raise prices at the expense of consumers, there is an inefficient allocation of resources; consequently, the government often has to regulate them. Many public utilities are regulated monopolies. Monopolistic Competition. Monopolistic competition refers to a market whose products are heterogeneous but is otherwise the same as a market that is perfectly competitive. The following conditions must exist: 1) a large number of participants, 2) freedom of exit and entry; 3) perfect information; and 4) heterogeneity of products. The first three are also characteristics of perfect competition. Each firm has a "partial monopoly" of some product characteristics, because of product differentiation. The demand curve is downward sloping. An increase in the price of a firms product under monopolistic competition may reduce the quantity demanded, but customers can remain loyal to the product because of such differentiation. Many product brands in the market belong to this category. Monopolistic competition is common and widespread in retailing: restaurants, shoes, soft drinks, soaps, household articles, personal care products, and gasoline are just some examples among many. Many of these products are the subject of rather heavy advertising through print, television and other media designed to promote brand recognition and loyalty by customers. The monopolistic competitor maximizes profits by equating marginal cost (MC) and marginal revenue (MR), like that of a monopolist. However, the demand curve is often flatter (more elastic) because there are more close substitutes for the monopolistic competitors product. Oligopoly An oligopoly is a market structure dominated by a few sellers, at least several of which are large enough in relation to the total market to be able to influence the market price (Baumol and Linder 281). Each member firm in the industry carefully monitors the major decisions of its rivals and often prepares strategic plans to counter potentially adverse moves. There is an interdependence of decisions among these rival firms, making the study of this market structure often complex and difficult and the outcomes unpredictable. The tactics used, the moves and counter-moves employed, are often compared to a military operation. When firms engage in a "price war," each firm tries to outsell the other firms by setting its prices lower whether or not they cover its costs. The other firms retaliate with deeper cuts of their own, then countered by another price cut by the rival firm. This can go on until one or more firms give up and allow themselves to lose. If a firm thinks that its rivals will match any price reduction but fail to match a price increase, its demand curve is "kinked" -- which means that the price will be be adjusted less frequently ("sticky") than under perfect competition or monopoly. It would be unprofitable for any firm to initiate a price reduction because it will be matched by the competitors and they would all lose; but a price increase by one firm may not followed by the others, thus the price-increase initiator can lose sales volume and customer loyalty to those who decided to stay put with their prices. On the other hand, the industry can sometimes agree on price leadership by which one firm which is credible sets the price and others merely follow. It is thus difficult for an oligopolist to unilaterally set prices without affecting its sales volume and profitability. Competition is quite strong and direct in the industry. Price collusion is harmful to the consumer welfare and is considered illegal. In some cases, however, such as those carried out by international cartels (e.g., OPEC) , prices and quantity can be managed and controlled by the cartel. Examples under oligopoly market structure are steel, aircraft, automobile, computers and other IT products. The largest share of national output are attributable to oligopolists despite the fact that they are few in number. It is sometimes said that the revenues of some of these individual oligopolistic firms exceed the national income of some small industrial countries of Europe (Baumol and Linder 275). Conclusion Competition among firms providing goods and services to the consumers can result in lower prices and greater volume of what is available. This is true in an ideal situation of perfectly competitive market where there are many sellers and buyers, and where price equilibrium is determined by the law of demand and supply. On the other hand, there can be a less efficient allocation of resources under the opposite extreme of the monopoly where the industry is composed of only one firm. The monopoly can bring about production efficiencies on account of mass production and economies of scale; but without government control or regulation, it can charge abnormal prices. This is far from what Adam Smith in his theory of the invisible hand had envisioned for our free market economy. Somewhere In between is monopolistic competition, slightly different from perfect competition but producing the greatest variety of products actually produced by firms and consumed by society. The use of advertising and product differentiation may add a little cost to the price setting of goods and may entice consumers to prefer certain brands to actual value. Another is oligopoly, characterized by few sellers and robust competition among member firms. The nations biggest firms in terms of assets and revenues belong to this category. While competition can be strong and good for consumers, there are cases when tacit collusion and cartel activity can occur and cause some prejudice (or dead-weight loss) to consumers. The businessman would find it useful to understand the different market structures and how they operate in order that he can be properly oriented before joining an industry and before conducting some transactions with members of any of these market structures. BIBILIOGRAPHY Baumol, W. J. &, A. S. Blinder. Microeconomics: Principles and policy. 7th ed.. Orlando, FL: The Dryden Press, 1997. Baye, M.R. Managerial Economics and Business Strategy. (6th ed). New York: McGraw Hill, 2000 Frank, R.H. Microeconomics and behavior. 3rd ed. McGraw Hill, New York, 1997. Nicholson, W.E., Intermediate microeconomics and its applications 7th ed. The Dryden Press, Orlando, FL, 1997 Spencer, M.H. & O. M. Amos Jr, Contemporary microeconomics 8th ed. Worth Publishing, New York, 1993 Truett, L. J. & D. B. Truett. Managerial Economics: Analysis, Problems, Cases. 8th ed. Hoboken, NJ: John Wiley & Sons, (2004). microeconomics. Accessed October 23, 2008 .http://www.investopedia.com/terms/m/microeconomics.asp). 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