The Different Level of Profits in Different Market Structures - Essay Example

The different level of profits in different market structures Introduction The term market in economics represents the interaction between groups of economic agents, namely firms and individuals, who interact with one another in a buyer-seller relationship. In economics, there are four different types of market structure, such as, perfect competition, monopoly, oligopoly and monopolistic competition (Wilkinson, 2005). The basis of this difference in the market structure arises from five major factors: Number of sellers and buyers in the markets. Type of products that are sold in each of the market. Barriers to entry in each of the market types. Power of the markets to affect the price. Extent of non-price competition in the market. This study focuses on two of the contrasting market structures, namely perfect competition and monopoly. The various assumptions regarding these two market types and profits earned will be discussed in details in the following sections. The market structure analysis Monopoly The basic assumptions of monopoly are: Firstly, there is only one seller in the market with multiple buyers, which allow the seller to set prices of the products. Secondly, the seller sells a product that has no close substitutes in the market. This means that there is no threat of competition from any rival seller, as no seller can produce the product that is being produced by the monopolist. Thirdly, barriers to entry into the industry are extremely high, in case of monopoly, which makes it difficult for any new firm to enter the market. Finally, as the product has no substitutes and the seller is the price setter, monopoly does not have to rely much on non-price competition, like, heavy advertising. As there are no competitors in monopoly, the price to be set and profit maximization depends on the demand curve. The monopoly firm equates marginal revenue to the marginal cost to determine the appropriate amount of output. It then uses the demand curve to find out the price it should charge from buyers. Once the price to be charged and the quantity are determined, the monopolist can then see the profit it can make (Mankiw, 2011). The profit that can be earned by the monopoly is expressed as: Profit= TR – TC TR= Total Revenue TC= Total Cost The profit that is earned by a monopolist is presented in the following diagram: Figure 1: Profit maximization under monopoly (Source: Authors Creation) The shaded area in the graph shows the total profit that is earned under monopoly. The height of the box shows the extent to which the price is higher than the average cost and breadth of the box portrays the number of units sold. Multiplying these two, the firm can determine its profit. Perfect Competition The assumptions underlying the market structure of perfect competition are: Firstly, there are many sellers in the market, which renders firms operating under this market structure as price-takers and none of them can influence the price of the product individually. Secondly, it is assumed that all sellers are producing a homogenous product and are perfect substitutes of one another. So, every seller is a direct competitor of the other. Thirdly, there are no barriers to entry into the industry by a new firm because of the above two assumptions. Any firm willing to exit the industry can also do it without facing any barrier. Fourthly, there are no non-price competition factors, like, advertising, as all sellers sell a single homogeneous product. The optimal output to be produced is determined from the equalization of marginal revenue with the marginal cost. The price that is set by firms in competitive market is determined by the intersection of price with the marginal cost (A. J. Hoag and J. H. Hoag, 2006). The following graph shows the profit maximization by a firm in perfect competition: Figure 2: Profit maximizing under PC (Source: Authors creation) The firm will produce as many units as is marked by point Q because producing any amount below this will result in positive marginal profit and that above this will cause negative marginal profit. One of the primary differences between perfect competition and monopoly is that, in case of monopoly, price is set above the marginal cost; and in case of perfect competition, price is equal to the marginal cost (A. J. Hoag and J. H. Hoag, 2006). The theory of perfect competition states that a firm can earn only abnormal profits in the short run, but in the long run, it can earn normal profits only. Normal profits indicate the minimum amount of profit, which is required by a firm to remain competitive. It occurs when total revenue becomes equal to the total cost. Abnormal profits also go by the name of supernormal profits and measure any level of profit that is above the normal profit (Armitage, 2005). The theory of perfect competition states that if firms are enjoying abnormal profits in the short run, then it will induce more firms to enter the industry. This in turn will cause a shift in the supply curve to the right and price will be lowered. This process will continue till all the abnormal profits are eliminated and firms only enjoy normal profits. Similar conditions will operate when firms are earning losses. The losses incurred will prompt firms to leave the industry and supply curve would shift to the left, thereby raising prices in the industry. This will again restore the situation, where firms can only earn normal profits (Gillespie, 2001). A monopolist can earn abnormal profit, normal profit or losses in both long and short run. There are two conditions that need to be fulfilled for attaining equilibrium. The first one is that the marginal revenue (MR) must be equal to marginal cost (MC) and the second one is the MC curve should cut the MR curve from below. In short run, the level of output can be changed by the monopolist, depending on restrictions imposed. If average revenue (AR) of the monopolist is higher than average cost (AC), then he will earn abnormal profits. If AR=AC, then the monopolist will earn normal profits and if AR Read More