What Is a Market Structure - Essay Example

Market Structure Introduction In economics, market structure can be defined as the collection of factors that determines the interaction of buyers & sellers in the market and controls price movements, production & selling process in the market. In other words, market structure is the no of firms producing identical goods & services in the market, which are homogeneous in nature. The four basic types of market structures are: Perfectively Competitive Market. Monopolistic Competition. Oligopoly Market & Monopoly Market. To determine the major characteristics of Market Structure, economists have focused on the factors like nature of competition prevailing in the market & the mode of pricing. The system is greatly influenced by the behaviour of individual firms in the market as well. Market structure is also affected by the decision of the individual firms in setting up prices within the industry & the supply of different commodities in the market. For example, when competition is high, firms tend to supply more & more in order to capture handsome market share. Barrier to entry is also an important factor to determine market structure. In a monopoly market structure, the degree of barriers to entry is much higher than in a perfectly competitive market, where the factor may have a zero percent influence. Another factor of consideration to understand market structure is market efficiency. A firm will operate more efficiently in a competitive market with a fear of losing opportunity rather than a firm operating in a monopolistic market (Cohen, 2010, pp.131 –133). The features of Market structure can be attributed as: No. of firms operating in the market (in local & foreign market both). The market share held by the large companies i.e. the concentration ration of market. The nature & amount of cost involved in the market which indicates the degree of economies of scale the market is enjoying & the level of sunk cost. The degree of vertical integration i.e. the system of managing different stages of production & distribution by a single enterprise. Degree of product differentiation. Customer turnover ratio i.e. the no. of customer willing to change their consumer preferences due to change in market structure, over a period of time. This factor is an indicator of brand loyalty & reaction of marketing activities such as advertisements etc. To analyse Market Structure from economics point of view the major areas of consideration are: The no. of buyers & seller present in the market. Scope of product substitution. Analysis of competitive costs. Opportunities of entry & exit for competitors. Extent of mutual interdependence i.e. to what extent the buyers & sellers present in the market, are dependent on each other. Discussion To understand the Market structure in broader terms, various types of market structure, mentioned above, should be discussed. Perfectively Competitive Market A perfectly competitive market indicates a market condition where a large no. of buyers & sellers has the market power to set the price of homogeneous goods & services. In a perfectly competitive market, the no. of buyers & sellers are so numerous & well structured that the market price of commodities are beyond control of the individual buyers & sellers and all the monopolistic powers are eliminated from the market (Wong, 2010, pp.1174–1177). A market to be perfectly competitive must possess the following characteristics: All firms are price taker, having a relatively small market share, operating on a profit maximization objective. The firms sell identical, homogeneous goods, having perfect knowledge about product quality, price & cost. The industry is free from any entry & exit barriers, factors are perfectly mobile. In a perfectly competitive market, all firms are price taker. Seller must take the existing market price. If a single firm is charging a price above the market price, this will result in a loss of potential buyer of the firm. Similarly, setting price below the market price results in either a reduction of profit for the firm or the possibility of customers’ questionability on quality issue. The firm can sell as much quantity as possible at an existing market price i.e. demand is not constant for the firm. Revenue can be derived simply by multiplying the market price to quantity demanded. Marginal Cost varies depending upon the quantity produced. So, the firms are expected to increase the inputs to the point where marginal cost is equal to the market price. In short run, firm will produce as long as average variable cost is lower than market price. If the market price is lower than the average cost but greater than the average variable cost, the firm still continues to operate in short run as there is no scope for recovering fixed costs in short run. So, most of the firms operates in a short run perfectly competitive market in such a manner that results in making abnormal profit. Over long run, the firms are required to cover all types of costs in order to continue their production process. If most of the firms are making abnormal profit in short run, there will be a huge scope of expansion of output for the existing units which lead to entry of new firms in the industry. As factors are perfectly mobile in such market, firms making supernormal profit may lead to relocation of existing resources within the market. Furthermore, addition of new suppliers results in an outward shift of market supply curve. Assuming that, the market demand remains unchanged, an increase in market supply will reduce the market price, until, price= long run average cost holds good. It this intersecting point, each firm is making normal profit & there is no scope for the firms to go out of the industry. This is the long run equilibrium condition for a perfectly competitive market. The firms start making normal profit at the profit maximizing output level. This is an economic situation that doesn’t exist in practical world. The concept of free entry & exit, identical products or perfect knowledge doesn’t hold well in real world. However, fish or vegetable market can be brought into such market classification where a large number of buyer & seller come together for sale - purchase activity, all of them having good knowledge of what they are buying. Government of the country also tends to intervene in a perfectly competitive market mainly due to the fact that Government has a responsibility to regulate the free market economy. Taxation is also a most important factor from Government’s perspective in order to fund them to run the economy successfully. However, it is a proved fact that taxation distorts a free market which in turn hinders economic growth & stability issues. Hence, Government controls a perfectly competitive market by subsidizing foreign demands for agricultural product, buying surplus, encouraging farmers to produce within a certain limit etc. For many industries say automobile or manufacturing sectors, barriers to entry plays a significant role such as high start up cost, strict government regulations, imperfect information of buyers due to presence of a large no of alternative in the market (FMCG sector). Monopolistically Competitive Market In a Monopolistic Competitive Market imperfect competition prevails such that a large no. of producers sell differentiated products (by branding or quality) i.e. products are not at all perfect substitutes. In this type of market structure, production does not take place at a lowest possible cost mainly due to the fact that firms are left with excess production capacity (Feenstra, 2010, pp.17-21). The main characteristics of this type of market are as follows. Existence of a large no. of producers & consumers but one is having total control over market price. Consumers perceive non price differences among competitor’s product. Producers having a degree of control over prices. Few barriers to entry & exit, product differentiation & independent decision making of consumer. A firm operating in a monopolistic competitive market considers contradictory factors to increase total revenue. Reducing price to increase quantity of goods sold but this reduction in price is also applicable to the quantities sold at a lower price, which could have been sold at a higher price. Hence, profit is maximized by adjusting output & price, until the marginal revenue comes at the same level of marginal cost. As new firm enters the market, demand of the existing firm becomes more elastic. As a result demand curve shifts upward, reducing the price level. In long run, the characteristics of a monopolistically competitive market are same as perfect competition except from the fact that monopolistic competition deals with heterogeneous products & it involves non price competition. In long run, a monopolistically competitive firm makes zero economic profit as firms making profit in short run will experience a reduction in demand in long run at the expense of increasing average total cost. Though because of brand loyalty, the firm may increase the price level without losing its customer base; most of the firms try to derive as much benefit as possible in short run through innovation & product differentiation. The majority of the small scale business operations operating in the real world are monopolistically competitive. Many small businesses operate under such market structure such that independently owned enterprises- street restaurants, each stalls offering something unique, though competition for the same chunk of customers. In Monopolistic Competition, a barrier to entry is low. In this type of market, in contrast to the perfectly competitive market, price is higher & output is lower. The cost of product differentiation & advertisement is borne by the consumer only. In this scenario, if the barrier to entry is low, firms still get an opportunity to produce efficiently, use valuable resources & product differentiation. Entrepreneurs may have more incentive to operate in such market as price cannot be extreme, if market is contestable. Oligopolistic Market Structure In an oligopolistic market structure, a small no. of firms constitutes the industry and this group of firms has control over price. The products produced by the firms are nearly identical; hence firms competing for market share are identical. A barrier to entry is very high. Oligopolistic market structure gives rise to collusion which reduces competition which leads to higher prices for consumers. Decision taken by one firm is highly influenced by decision taken by other firms. Cartel, Price Leadership Model & applications of Game Theory are used to determine price- quantity levels of Oligopolistic Market. Main characteristics of this market structure are: Firms operate in a profit maximization condition where the firms having the ability to set price level. Products many be homogeneous or differentiated depending on the industry of operation. Firms under oligopolistic structure have knowledge about their own cost & demand function but inter firm information are incomplete. Oligopolies have strong intentions to collude & individual oligopolists have an incentive to cheat because firm’s demand curve is more elastic than overall market demand curve. So, by secretly reducing price, the firm can sell to those customers who were not willing to buy at a higher price as well as to the customers who would buy the product from other firms (Ishida & Matsumura, 2011, pp.498-502). In this market structure, within a longer time period, more firms are attracted to the industry in order to capture potential economic profit. Hence, entry barriers lower which is not be sustainable. An important example of oligopolistic market is OPEC which proficiently influences international price of oil. Apart from that telecommunication sector of India & insurance sector of many countries, computer operating system, smart phone operating system show oligopolistic market structure. Government control is important in Oligopoly market in order to restrict collusion & decision making of the firms. For example, airlines industry used to enjoy oligopolistic market structure. But, Government intervention to restrict collusion among the existing firms to keep price high resulted in more healthy trade practices, fair competition & lower prices. So, government should ensure the competitiveness among the oligopolistic firm but they should not impose excessive regulatory strictness that may lead to restrictive trade practices or burning competition. Monopoly Market Structure A monopoly market structure is characterized by a single supplier selling unique product in the market i.e. a single firm controlling 25% or more of a market. In this market structure, seller faces no competition, being the only supplier of his goods with no close substitute. Here, the seller is price maker. Characteristics of the market are as follows. In monopoly market, firms are price maker. A monopolist can change the price & quality of his product according to his own preferences. He can charge lower price in a very elastic market & comparatively higher price in less elastic market which give rise to price discrimination. Monopolist can control both quantity produced & price change. So, in monopoly market, the demand curve is downward sloping. Profit is maximized where marginal revenue meets the marginal cost. As the demand is not known to the monopolists, optimum price should be established at profit maximization equilibrium point. In long run, economic profits are eliminated which is the only equilibrium consistence with the assumption of low barriers to entry. This is achieved at an output, where price is equal to long run average cost. So, the difference with perfect competition or monopolistic competition can be directed in monopolistic competition, the point of tangency is downward sloping & it does not achieved at minimum of average cost curve. The main reason behind this is the downward sloping demand curve (Nadala & Vannimenusa, 2005, pp.1174–1177). The cable company, electricity suppliers are examples of Monopoly Market. In a monopoly market, factors like government licence, legal barriers, copyright & patent, ownership of resources, technological superiority etc that involves high start up cost leads to few entries in the market. Though Government imposes strict supervision & regulations on, they loosens licensing restrictions on some of the areas of operation, such that power supply & electricity, water supply etc and allow the firms to enjoy natural monopoly in order to reduce cost & control duplicity. Conclusion From the above discussion on different types of market structure and their characteristics, it can be inferred that, in order to establish business or enter into a new market, market should be chosen depending on the nature of business, scope, existing market players, industry performance in past decade, nature of competition prevails on the market. For example, if the new entrant wants to inter in international trade as well, he may enjoy the facility of price discrimination in monopolistic market where he will be able to charge a lower price in domestic market & a higher price in international market. Similarly, the firm may constitute cartel with few existing oligopolistic market players. If he wants to capture the niche market & earn profit with a little initial investment, he may opt for monopolistic market. So, choosing market for business operation based on such economic criteria may lead to enjoy the inherent & continuous profit to the stakeholder. References Wong, A. C. L. (2010). The rate of convergence to perfect competition of matching and bargaining mechanisms. Journal of Economic Theory (I), 145 (3), 1164–1187. Nadala, J. & Vannimenusa, J. (2005). Multiple equilibriam in a monopoly market with heterogeneous agents and externalities. Journal of Quantitative Finance (I), 5 (6), 557-568. Feenstra, R. (2010). Measuring the gains from trade under monopolistic competition. Canadian Journal of Economics (I), 43 (1), 1-28. Ishida, J. & matsumura, T. (2011). Market competition, R&D and firm’s profit in asymmetric oligopoly. The Journal of Industrial Economics (I), 59 (3), 484-505. Cohen, W. (2010). Fifty Years of Empirical Studies of Innovative Activity and Performance. Handbook of the Economics of Innovation (I), 1, 129–213.   Read More