Economics of Competition - Assignment Example

Economics of Competition Answer MES or minimum efficient scale of production of a firm is the amount of production when the long-run average cost is at its minimum. At MES a firm can take the full advantage of the economies of scale with regards to the cost and supplies. When MES is compared with the market demand, it provides important implications on the total number of firms serving the market when the cost minimisation is the objective. The comparison between MES, which is obtained from the long-run average cost curve and the maximum potential market, obtained from the market demand gives conclusions about the market structure. Although the MES gives a range of production values, but its relationship with the market determines how many firms can operate effectively in the market. When MES is significantly smaller compared to the market demand then the market will be concentrated with small firms, each producing a very small market share. In this case, the firms which are comparatively small will enjoy cost advantage over the larger firms. Consequently, the economies of scale are exhausted rapidly. An example of such a case is the market for personal services. If MES is too large than the market demand then the market will not have too many firms. In fact, as the economies of scale increase more concentration of firms will be observed in the market. When MES is one quarter of the market demand, then the market observes few large competitors. Such market economies of scale are created with huge amount inputs until each of the firm expands enough to produce a large share of the market. Answer 2 Economic theory explains that perfect competition is the most socially optimal market structure. But in reality markets always deviate from perfect competition reducing the social welfare. Departure form the perfect competition gives way to the market power. Most of the markets contain large firms and the presence of even a single large firm is sufficient to influence the price through output adjustment. Large firms are always coupled with cost advantages which help them to enjoy the economies of scale. And this ability of influencing the market price is termed as market power. Highly concentrated market involves accumulation of very small number of firms sharing larger shares of the market. Such a condition is not desirable since it leads to high prices and low outputs. Consequently the firms existing in such market accrue high profits and sustain for a long period of time. These firms, earning high profits, tend to lower the competition level in the market. Influencing the price thorough output adjustment is not the only way of using the market power by these firms. There are other ways to use the market power. The larger firms enjoying market power tend to concentrate more on the highly profitable areas of the market leaving behind the areas which are less profitable. Firms with market power can also drive down the price it pays to the suppliers. This tends to reduce the supplier’s profit and disturbs their motivation to produce. Product differentiation is another source of obtaining market power by the large firms. All the aforementioned means to obtain market power makes it difficult for the new firms to enter the market as the cost of entry becomes high for them. As a result the high concentration in the market exists and the firms within the market keep accruing higher profits. Answer 3 The incident of market failure arises when the resources are inefficiently allocated due to the distortion in the price mechanism. The price mechanism breaks down in a market because of the factors like monopoly power, existence of merit goods, existence of public goods, factor immobility etc. The existence of market failure can be corrected with the proper and justified state intervention in the market. Thus public policies play an important role in eradicating market failure and restoring an efficient resource allocation in a market. There are several sources of market failure that are observed in a real world. Market failure occurs with the introduction of public goods. Public goods are non-rival and non-excludable implying that the consumption of the goods by one person does not harm the consumption by another person. Common examples of public goods are defense, medical care, and public health. The possible government intervention in this kind of market failure is by introducing public provision of these services. Market failure arises when there are externalities in a market. In case of externalities, actions of one firm affect the cost or benefit of another firm. In case of positive externality, action of one firm benefits the other firm. And in case of negative externality, action of one firm increases the cost of another firm. Common example of such market failure is pollution caused by fumes in a factory. Both these situations can be controlled by introducing taxes, subsidies and creating property rights. Market failure can also arise when a firm enjoys increasing returns. Increasing returns are observed when a firm’s total average cost decreases as it increase its output. Such a situation can give rise to natural monopolies. In such a case government intervention has to be introduced in the firm of public ownership. In case of a highly concentrated industry, the firms enjoying market power also creates market failure. Such firms influence the price by reducing output. Such a situation can be controlled by the government through the removal of market barriers. Answer 4 N firm concentration ratio is the measure of industry concentration. It is measured simply by adding the market shares of the N large firms in the industry. Among this measure the 4 firm ratio (C4) and 8 firm ratio (C8) are most commonly used. The N firm concentration ratio usually takes sales revenue as the parameter. Leamer introduced the N firm concentration ratio which is a simple calculation and thus it gives the result of seller concentration very easily. It also has a systematic approach as it takes into account the sales revenue of the firms. It is also backed with proper logic in terms of its construction. Despite being simple and systematic the N firm concentration ratio is associated with some serious disadvantages. When the N firm concentration ratio is constructed, it is seen that the value of the ratio cannot be greater than 100%. The value can only be near to 1 if the largest N firm accounts for majority of the total industry output. But problem arises when same value represents three different market structures. 1. In case of monopoly the C4 concentration ratio is 100%. 2. In an industry where four large firms exist with equal share the C4 concentration ratio is 100%. E.g. (.25+ .25+ .25+ .25) 3. In an industry with four unequal large firms which can give a C4 ratio of 100%.e.g.(.4+ .3+ .2+ .1) The N firm concentration ratio value thus produces same result for three unique market structures. The value of N is chosen according to the type (more or less) of the concentration in the industry. The value of N ignores any firm beyond the prescribed limits i.e., 4 or 8. The N firm concentration ratio thus needs to take into account the changes in the proportion of market share by large firms. Answer 5 N firm concentration ratio has been the most popular measure for industry concentration. But it was detected with a serious shortcoming. The ratio produced the same result for three unique market structures. Hence, there was a need to develop a measure that varied along with the change in the proportion of market share held by the large firms. Herfindahl–Hirschman index on the contrary produced more reliable results. Herfindahl–Hirschman index is measured by adding the squared market share of each firm in the industry. The use of square values for calculating HHI inflates the larger market share taken into consideration. This helps to create a more precise measure of industry concentration. Thus the value of HHI will be greater if there is greater inequality in the market share. Unlike N firm concentration ratio, Herfindahl–Hirschman index included all the firms in the industry and not just the few large firms. This helps to sum up the complete concentration curve rather than concentrating on a single point. The HHI produces unique result for different market conditions. As a common rule, value of HHI below 0.1 implies low concentration and a HHI value above 0.18 gives signal for high concentration. The range between 0.1 and 0.18 shows a moderately concentrated industry. In case there is a market situation where all the firms have equal market share, the reciprocal value of HHI will produce the number of firms in the industry. In the industry where firms have unequal market shares, the Herfindahl–Hirschman index will indicate the ‘equivalent’ number of firms. Thus the Herfindahl–Hirschman index takes into account all the necessary points that were ignored while constructing the N firm concentration ratio. The HHI thus has numerous practical applications. The HHI is used in the department of justice merger guideline. According to its calculation of HHI, it challenges those mergers which can prove to be harmful for the consumers. Read More