Market Structure and Efficiency - Literature review Example

Market Structure and efficiency According to Samuelson and Nordhaus (2005), efficiency in a market occurs when no possible reorganization of production can make any one better off without making someone else worse off. Under an efficient market, one person’s utility can be increased only by reducing utility of someone else. Market structure i.e. prevailing competition and cost, determines the efficiency present in the market. Perfect competition is the most efficient market structure while imperfect competition leads to inefficiency in the market. Perfect competition allocates the resources most efficiently In perfect competition, MR = AR = D, because the demand curve has infinite elasticity as even a slight change in price will lead infinite change in demand. P = MU consumers choose purchases up to the amount where P = MU P = MC Each seller sells up to the point where P = MC Thus MU =MC The utils gained from the last unit consumed (purchased) is exactly equal to the cost of the last unit produced. At this point marginal gain to society (MU) is exactly equal to the Marginal loss (MC) to the society. This point guarantees that a competitive market is efficient Example, though there exist, no exact examples of Perfect Competition, there may be certain markets that approximate perfectly competitive markets. For e.g. FOREX market In the FOREX market only one commodity is traded i.e. US $. The prices world over are highly converged with just a very small amount of arbitrage possible that too for short period of time. The sellers in the market charge similar prices which keeps P = MR and for profit maximization the firm operates at a level where MC = MR, MC also equals to P i.e. MC = P. Thus there is no possibility of increasing the overall well being of the society. Thus the situation can be called as Efficient. Refer Figure 1. Fig. 1 Figure 1 shows the profit maximizing point for a competitive market firm. The point for profit maximization is qe , as here MR = MC and since its perfectly competitive AR = P = MR, thus MC = P, which signifies the efficiency in the market. Imperfect Competition When perfect competition is not there (Monopoly or oligopoly) by definition a firm will have some power in the market (differentiated product). The firm can charge a price above its marginal cost. P > MC The higher price will lead to customers buying less of the product than they would under competition. This will result in reduction of satisfaction which will be a source of inefficiency in the market. Example of imperfect competition or inefficient market can be personal computer market. There are so many small and big players offering differentiated products. Since the product is differentiated each seller charge a price higher that its marginal cost. So the firm will charge a price P higher than MC i.e. P > MC In this situation it is possible to increase the satisfaction in the society as the cost incurred by the society i.e. MC is less than the satisfaction derived by the society i.e. Price ( utils), it is possible to increase the overall satisfaction of the society by producing further till MC rises and equals price i.e. MC = P, but for the firm this will not be the point where MC =MR as MR is not equal to P thus the firm would not this point where MC = P because then MC will not be equal to MR thus not ensuring the maximum profit. Profit Maximization for Monopolist. The profit Maximizing point is where output is 5 at price 100. Since here at equilibrium point MC = MR, price is higher than MC i.e. P > MC. Since P > than MC it’s not an efficient point. Ans 2 Advertising in saturated markets may not aim at increasing the size of the industry but eating in to competitors’ market share. In such a situation firms try to snatch customers away from their competitors by either spending heavily on advertising or waging price wars. The example of such a market could be Cigarette market in US around 1950, refrigerator or TV market in country like china which historically did not involve in innovation. This is classic example of one shot prisoner’s dilemma. Let’s say firm X and Y both enjoy 50% market share each. The total market demand is $10 m. The firms have two options i.e. either run an ad campaign or don’t run it. The cost of running the campaign is $2 m and if one firms runs the campaign and the other one does not, then the firm will gain 80% share and the other one will be left with remaining 20% share. Let’s consider the variable cost is negligible in this case. While if both of them run it the market remains the same that is $10m and both the firms with market share of 50% as their campaigns cancel out each other. If both X and Y run the campaign – Both incur $2m as advertising cost and earn revenue of $5 m resulting in a payoff of 5-2 = $3m. Represented in cell A If X runs the campaign and y does not or Y runs and X does their pay off will 6 and 2 or vice versa. These are represented in cell B and C respectively. If both refrain from running the campaign – both retain their earlier revenue without any outlay of money on advertising. Pay off Matrix for the firms X and Y If both firms act rationally, both will think of maximizing their inflows. Let step in to the shoes of firm X – Firm X sees that the highest net inflow is $6 m in cell B that is when it campaigns and Y does not. But if it campaigns Y also campaigns its net inflow will be just $3 m. Firm X can no way know what Y would do. Thus for X the better option is to campaign as if it do so, whatever Y does it will be better off than if it had chosen not to campaign. See for X cell A and B offer higher pay off than C and D respectively. So it finds that this strategy of campaigning dominates the other strategy. Firm Y will also think in the same manner and find that for it the strategy of campaigning dominates. Though both the firms know, that since campaigning is the dominant strategy for both of them; they will end up in cell A with just $2m each. They could have chosen a better cell i.e. D in which both would have enjoyed 5m each but they don’t do so as they can’t trust each other and if they choose not to campaign and the other one betrays they would be worst off. Since it is not possible to reach an agreement enforceable under law, related to advertising, both firms end up spending huge amount n advertising not getting any extra sales but just keeping their earlier sales intact. Had there a been possibility of such contract the equilibrium would have set at Cell D which would offer highest net inflow for both of them.One such example is there of American tobacco industry which endorsed banning of cigarette advertisement as due to this all firms were bound to refrain from advertising and it saved millions of dollars for them every year which were to be spent on advertising. b) A similar situation arises when firms engage in price wars especially when there is no possibility of increasing overall industry demand. The firms reduce price for their own losses (or reduction of profits). This is also a case similar to prisoner’s dilemma. Let’s consider that these two firms i.e. X and Y are also considering reducing price of their products. The conditions are as follow Both have sales potential of 3 m each ( 5m -2 m) overall sales potential is 6 m as they have committed 2 m each for advertising. These firms face a situation, in which increasing overall sales of the industry is not possible. They however have an option that if one firm reduces the prices by 20% it can gain have sells of 75% share and the other firm gets only 25 % in unit sales. But if both reduce the price the sales remain flat i.e. 3 m each for the firms. Let’s consider current price is $1 per unit. Pay off Matrix for X and Y Again we see X will think that for the dominant strategy is to cut the price as it will be better off than the other wise situation irrespective of the fact what Y does. X will think that Y acting rationally would also come to the same conclusion and Choose its dominant strategy i.e. price cut. Both the firm know if they can cooperate and don’t wage price war both will be better off but again lack of trust will make them choose a strategy which will lead to further dent at their revenues and profits. This situation is more troublesome than the advertising war as mentioned firms can come to an agreement of not to advertise but coming to an agreement to charge higher prices is prohibited by law. Thus we see oligopolistic firms though through cooperation can enjoy the benefit by charging higher prices and spending less on advertisement but they will not do so because of lack of trust as both realize if they are suckered by the other firm they will be worst off. Ans 3 Rationale behind government’s intervention in producing public goods like clean air. Certain goods are such that the market will not be interested in producing them. These goods are called public goods. Thus to produce such goods becomes the government’s responsibility. This happens because of the two peculiar characteristics of such goods Non rival consumption – In certain goods it happens that consumption by one person does not prevent others from consuming it as well; even those others might not have for it. And when it is also difficult for the marketer to restrict the use to only those who have paid and exclude non payers from using it, it leads to a situation of free riding. These goods having this problem of free rider are said to be non excludable or non exclusive in consumption. For example - Street light. This may lead a lot of people willing to derive the benefit without having to pay for it, which makes it difficult for the marketer to recover the cost thus marketer may have to increase the price to recover the cost which would discourage others those who were ready to pay a normal price for the good. Goods and services characterizing both non rival and non excludable characteristics are called public goods. Externality – markets can deliver efficient quantity of goods and services only when both seller and buyer are ready to fully bear both the costs and benefit of their efforts. Markets may suffer with a problem of externality which happens when one party either incurs / derives cost or benefit out of someone else’ deeds with being compensated / paying for it. When there are benefits (positive externality) being derived by other firms without paying for it, the firm may not be motivated to make that effort which and under supplies and negative externality i.e. the cost of a firms deeds are to be borne by others without the firms having to compensate them would motivate the firm over produce the goods or services. Eg Positive externality – A firm invents while other firms just copy it without paying anything to the inventor. Plz refer diagram 1 Fig- 1. Positive consumption externality Fig 1 In this figure D reflects the marginal private benefit, that means this is what people will be ready to pay P = 8, but D1 being higher than D shows that society will be deriving some more benefit than they pay for, which would discourage the firm from producing Q* = 6 and it would restrict its supply to only Q = 5. Eg negative externality – A firm produces and pollutes the environment without having to compensate the society for the pollution it causes. Fig 2. - Negative production externality Fig 2 In this case the producer if not take in to account the marginal social cost and considers only marginal private cost then he will produce Q=5, but by imposing tax on pollution the government forces the producer to take in to account the social cost also, he must produce only Q*= 4 because after this every unit produced will have marginal cost higher than marginal benefit to the society. Other issues that may discourage the marketer from producing certain goods are Adverse selection – This is a risk of choosing or getting only those customer who are costly to serve and other profitable customers are not interested in buying the product Moral Hazard The customers after purchasing the good may indulge in a behavior which makes them unprofitable for the marketer to serve them. References Samuelson Paul A., Nordhaus William D. (2005) “Economics”, Edition 18th, pp. 148 -162, 168-178, Tata McGraw-Hill publication. Read More