Perfect Competition, Monopolistic Competition, Oligopoly and Monopoly - Essay Example

Market Structure of the Contents Contents 2 Introduction 3 Discussion 3 Characteristics of Perfectly Competitive Market 3 Characteristics of Monopolistic Market 4 Characteristics of Oligopolistic Market 5 Characteristics of Monopoly Market 6 Evaluation of markets in terms of price output decision (Similarities and Dissimilarities) 7 Short run phenomenon 7 Long run phenomenon 8 Economic Efficiency under Perfect Competition and Monopoly 10 Economic Efficiency in Perfect Competition 10 Economic Efficiency in Monopoly 11 Conclusion 11 References 12 Introduction In Micro economics, Market Structure may be defined as study of the number of firms operating in the market which are engaged in producing identical and homogeneous goods. Market Structure is characterised by the relative power of buyers and sellers prevailing in the market, level of collusion and competition among the firms existing in the market, degree of the firms to differentiate products and possibilities to enter and exit in the market (Kumar & Siddharthan, 2013). Market Structure in economics consists of four basic kinds of markets. These are, Perfect Competition, Monopolistic Competition, Oligopoly Market and Pure Monopoly Market (Mankiw, 2014). In a perfectly competitive market, the number of buyers and sellers are so huge that determination of market price for a commodity is beyond control of an individual buyer and seller. In case of Monopolistic Competition, differentiated (though not perfect substitute) products are sold by many producers which lead to imperfect competition. In Oligopolistic Market Structure, few firms control a highly concentrated industry as a whole and the benefits are shared between these two firms only, whereas Monopoly Market characterised by only one seller selling distinct products in the market which has no close substitutes (Hirschey, 2008). In this paper, the characteristics, similarities and dissimilarities of each market will be discussed broadly and degree of economic efficiency produced by the market will be analysed. Discussion In order to understand correlation among Perfectly Competitive Market, Monopolistic Market, Oligopolistic Market and Monopoly Market, the distinctive characteristics of each market should be analysed first. Characteristics of Perfectly Competitive Market In a perfectly competitive market, large number of buyers and sellers exist where customers are willing to buy product at a certain price level and similarly, sellers are willing to sell their product for a specified price level. Barriers to entry and exit is restricted for the firms operating in a perfectly competitive market. Factors of production are perfectly mobile in long run perfect competition. Information related to quality of product, price and method of production etc are completely available to the consumers. Transaction cost is zero which means that buyers and sellers do not incur cost for exchanging goods in a perfectly competitive market (Wong, 2010). Profit maximization is achieved where marginal cost intersects marginal revenue. Producers produce homogeneous products which hardly differ in terms of quality or prices. Existence of large number of firms in the perfectly competitive market results in absence of economies of scale in the market. (Machovec, 2002). As all information is available to the buyers, buyers become proficient to purchase rationally. There are no externalities affecting the market i.e. cost of benefit cannot influence any other party. Clearly specified property rights help the buyer to understand their rights and direct the market to work accordingly (Machovec, 2002). Local Vegetable Market is an example of perfectly competitive market. Characteristics of Monopolistic Market Existence of large number of small firms in the market is the most important characteristics of monopolistically competitive market. The firms are free to make decision upon setting prices, regardless of the decisions made by other firms. For instance, opportunities are there for a firm to reduce price of his product in order to increase sales as such action will not influence its competitor to take a prompt action. Firms engaged in a Monopolistic market sell non-differentiated products or in other words, differences are not that high so that consumer may select or eliminate the competitors’ product. Hence, products are closely substituted. As a result, cross price elasticity of demand for goods produced in monopolistic market is positive. Start up cost is very low for entering into monopolistically competitive market. Hence, it is evident that a large number of firms tend to enter in this category of market in order to sell their product. However, many firms go out of business as they are not been able to cover their fixed cost in long run and earn a positive profit. Hence, there are no entry, exit and sunk cost. Imperfect information also prevails in the market as no buyer and seller have complete information about the demand and supply of the products and services. Firms engaged in Monopolistically Competitive market are also characterised by their capability of independent decision making, giving no importance to the decision made by their competitors. A little lowering in price level in order to increase sales does not affect the pricing decision of any of their competitors. Hence, they are free to change their price and output level in order to maintain their targeted profit level. Monopolistically competitive firms enjoy a definite scale of market power. In other words, firms are able to raise its price level without losing its potential and existing customers. Similarly, price levels can be decreased by the firms in order to increase sales. he main source of market power of these firms is the existence of few competitive firms in the market and their capability of selling slightly differentiated products. Such market power makes the firm’s demand curve downward sloping and highly elastic (Feenstra, 2010). Street side fast food restaurants are perfect example of monopolistically competitive practices. Characteristics of Oligopolistic Market Main characteristic of Oligopolistic Market is that the firms engaged in such market structure are highly interdependent in the process of decision making. The reason behind such interdependence is existence of low competition within the few firms in the industry and as a result, a slight change in price level of one firm will have a direct impact on the price and sales of their rival firm (Puu & Sushko, 2002). Firms under oligopolistic market enter into cut throat competition in order to capture more and more market share and to maximize their output. In order to achieve that, firms adopt various measures such as sales promotion or advertisement. In contrast to other market structure, where sales promotion does not hold good, such expenditure is a necessity for oligopolistic firms. Existence of price rigidity is very prominent among the firms engaged in oligopolistic market. Lowering the price level of one firm result in immediate price cut of the other rival firms. Hence, oligopolistic firms frequently engage into price war. Hence, no individual firm tends to cut in price level without calculating their price output decision as compared to the other firms existing in the market. Such exercise ignites price rigidity (Puu & Sushko, 2002). Together, the firms under oligopolistic market act as monopoly. In this type of market structure, firms act as a single unit through producing differentiated products and controlling price level and output. Such firms operate together for a motivation of profit maximization for all firms as a whole. As a result of interdependence among all firms engaged into oligopolistic market, uncertainties arise for demand of the products. Price and output cannot be determined for all firms as they cannot predict their rival’s price level, as a consequence of changing their own price level. Hence, demand curve in oligopolistic market cannot be determined as there is no definite relationship between quantity produced and quantity sold (Ishida & Matsumura, 2011). OPEC (Organization of the Petroleum Exporting Countries) was formed in oligopolistic nature for the purpose of controlling export of petroleum in international market. Characteristics of Monopoly Market Monopoly Market structure is characterised by a single seller selling unique products in market. In this type of market structure, a single firm controls at least 25% of the market. Hence, the seller is free from any competitor as he is the only supplier of goods which has no close substitutes. The seller is the price maker (Nadala & Vannimenusa, 2005). Monopoly situation arises when there is restriction from free entry and exit of new firms. Generally, in a monopoly market structure, firms and industry tend to be identical. If a number of new firms start entering in a monopoly market, the market will lose their monopoly power as supply of products cannot be determined by a single firm anymore. Normally, monopoly firms start enjoying profit in the long run only. Such profit can be abnormal in nature as in long run, monopoly firm has been able to establish it into the industry and acquire the power to control the industry alone. Absence of any competitor is another reason for a monopoly firm to incur abnormal profit as well (Nadala & Vannimenusa, 2005). However, in short run, monopoly firms tend to incur loss which is equal to the firm’s fixed cost. In fact, if monopoly is practised in an industry for which demand is very low, the firm will continue to suffer losses and finally, will go out of business. Demand curve in monopoly market is downward sloping. The reason behind the demand curve being less elastic demand curve as supply is controlled by a single firms. As supply is controlled by the firm itself, price is adjusted accordingly. Naturally, an increase in price level results in lowering quantity sold, hence making the demand curve slope downward. Ability of price discrimination is another distinct characteristic of Monopoly market. Charging different level of price for the same goods from different segment of customer is called price discrimination. In international trade, monopoly firms charge a lower price in home market and a comparatively higher price in the foreign market for same product. As the monopoly firms enjoy certain degree of market power, the firm is price maker in the industry. In monopoly, average revenue is always greater than marginal revenue. Hence, in order to increase sales, the only option to the firm is to reduce price level in order to increase output. Electricity supply or cable companies can be cited as examples of Monopoly market. Evaluation of markets in terms of price output decision (Similarities and Dissimilarities) Short run phenomenon In a perfectly competitive market, all firms are price taker operating in profit maximization motive. Profit is maximized in the intersection point of marginal cost and price level. In case of monopolistically competitive market, profit is maximized where marginal revenue is equal to marginal cost. If average cost is below the market price, the firm will tend to earn an economic profit. Figure1: Short Run Equilibrium in Monopoly, Perfect Competition and Monopolistic Market (Stackelberg, Bazin, Hill & Urch, 2010) However, in monopoly marker, profit is maximized where price level equals to the marginal cost of a firm (Nadala & Vannimenusa, 2005). Long run phenomenon Figure 2: Long Run Equilibrium in Monopoly, Oligopoly, Perfect Competition and Monopolistic Market (Nadala & Vannimenusa, 2005) In long run monopoly market, equilibrium is achieved where long run average cost curve intersects long run marginal cost curve and at that point of intersection, price and output is determined. Though short run demand curve cannot be determined under oligopoly market as a result of uncertainty in demand, in long run, price and output level is determined at a point where long run marginal revenue intersects marginal cost curve. (Nadala & Vannimenusa, 2005) In long run, price and output levels are determined in a perfectly competitive market where price level intersects long run average cost curve. Supply curve shifts outward as a result of expansion of the market due to entry of new firms, though demand curve does not change with an assumption that market demand is fixed at a certain level. In long run monopolistically competitive market, increase in supply of differentiated products lead to downward shift in market demand. Price and output is determined where long run average cost curve becomes tangent and the economic profit for the firm is zero (Nadala & Vannimenusa, 2005). Economic Efficiency under Perfect Competition and Monopoly Figure 3: Economic Efficiency and Production Possibility Frontier (Mankiw, 2014) Long run economic efficiency in any market structure can be attributed under two categories such that productive and allocative efficiency. Productive efficiency arises in case when goods can be produced at a lowest possible cost i.e. production efficiency is achieved along the production possibility frontier where increasing production of one good is impossible without reducing the production of another. In contrast, allocative efficiency leads to distribution and allocation of resources for the benefit of the society (Mankiw, 2014). Economic Efficiency in Perfect Competition Under perfect competition, equilibrium is achieved where price is identical to marginal cost in both short and long run. Hence, consumer and producer surplus are maximized as no one is better off by worsening the position of the other party. In this scenario, Pareto optimal allocative efficiency is achieved. Productive efficiency is also achieved in long run perfect competition when equilibrium output is determined at the minimal point of long run average cost Economic Efficiency in Monopoly As the monopoly markets have a certain level of market power, their ability to incur supernormal profit is occurred at the expense of economic efficiency and welfare from the societal perspective. Generally, marginal and average cost is higher than the price level in monopoly market which leads to loss in allocative efficiency for the industry as the higher price is extorted from the consumers only. Higher average cost indicates that firms are not engaged into optimum allocation of scarce resources, leading towards losing in productive efficiency. Hence, economic efficiency is achieved only under a market structure where perfect competition prevails (Mankiw, 2014). Conclusion After analysing different types of market structure and their characteristics, it can be inferred that before entering into a new market for establishing business, firms should consider factors such as nature of business, industry size and past performance of the industry, existing market players and degree of competition prevails in the market etc. For instance, firms with huge investment potential may enter into monopoly market as in this type of market structure; they will enjoy a degree of market power and will be able to gain advantage of price discrimination. Firms may also constitute cartel with few existing players in oligopolistic market in order to capture large market share, which was impossible for the firm to acquire if it was operating alone. Similarly, firms with smaller initial investment potential should enter into monopolistically competitive market (Cohen, 2010). Therefore, selecting market on the basis of these economic criteria may lead the firm to enjoy continuous profit in long run business operations. References Cohen, W. (2010). Fifty Years of Empirical Studies of Innovative Activity and Performance. Handbook of the Economics of Innovation (I), 1, 129–213. Feenstra, R. (2010). Measuring the gains from trade under monopolistic competition. Canadian Journal of Economics, 43 (1), 1-28. Hirschey, M. (2008). Managerial Economics. Boston: Cengage Learning. Ishida, J. & Matsumura, T. (2011). Market Competition, R&D and Firm Profits In Asymmetric Oligopoly. The Journal of Industrial Economics (I), 59 (3), 484-505. Kumar, N. & Siddharthan, N.S. (2013). Technology, Market Structure and Internationalization: Issues and Policies for Developing Countries. London: Routledge. Machovec, F. (2002). Perfect Competition and the Transformation of Economics. London: Routledge. Mankiw, N. (2014). Principles of Economics. Boston: Cengage Learning. 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. Puu, T. & Sushko, I. (2002). Oligopoly Dynamics: Models and Tools. Berlin: Springer Science & Business Media. Stackelberg, H., Bazin, D., Hill, R. & Urch, L. (2010). Market Structure and Equilibrium. Berlin: Springer Science & Business Media. 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. Read More