Demand in Imperfect Competitive Market - Assignment Example

TOPIC: MARKET STRUCTURE (NAME) (COURSE NAME) (INSTITUTIONS NAME) 26th NOVEMBER 2008 Question one Perfect competition refers to a market in which no single seller or buyer has market power. This means that the buyers or the sellers can not fix the prices in the market because prices are determined by the forces of supply and demand. P dd ss PiQi are the prices and quantities in the market. Pi fig (a) ss dd Qi Q In the short run, such markets are allocatively inefficient as well as productively inefficient. In the long term, such markets are both productively and allocatively efficient. In this regard a perfect competition market is characterised by the fact that no single entity or firm has got influence on the product price in the industry. Because the perfect market conditions are strict, there are few of such markets. Distinguishing characteristics of a perfect competition market include, Presence of many buyers and seller- The market has many consumers who have ability and willingness to buy products at a given price. The market has also suppliers who have the ability and willingness to bring their products into the market at a given price. Firms are price takers. A single firm can not be able to influence the price of the products thus any amount of output can be brought to the market at the market price. This is because of the numerous numbers of firms in the market, because of products that are not differentiated and availability of information to all market participants. (Henry, 2002) Homogeneous products- The products produced by different firms are similar, for example, salt or sugar. Perfect information- Both producers and consumers have perfect information about the market Free Entry and Exit- It is relatively easy to exit and enter into the industry without restrictions or regulations. Free exit and entry ensure that the producers in an industry can adjust to changing conditions in the market and that producers in an industry can not keep other firms out artificially. The aim of the firms is to maximize profits- The sole aim of the firms in the perfect competition market is to ensure they get higher profits by operating in a region where marginal costs meet the marginal revenue curve, that is, where they generate the highest profits. Question two The usefulness of a perfect competition market to the economists can be explained both in the short run and in the long run. In the short run, a firm’s demand curve is perfectly elastic at the prevailing price. The firm can sell more or less without having any effect upon the price. To the firm, the price and the marginal revenue are equal. To recap marginal revenue is the addition to total revenue due to the sale of an additional unit of an output. The amount of output a firm produces in the short run depends on its marginal cost and the price. Price fig (b) MC Equilibrium of the firm: price above P AC Price above average cost curve. AVC O A Qu Fig (c) Price MC Short run equilibrium of the firm p AC Price below average cost curve AVC O A Quantity Explanation The market price of a competitively produced and sold commodity fluctuates. But the fluctuations are not capricious or random. They have a pattern, hardly ever exact and closely predictable but nonetheless a pattern. The doctrine of short run equilibrium price is a way of stating the level around which market prices fluctuate in the short run. In figure (b) above the price is assumed to be at a level that makes the operation of the firm highly profitable. The price is OP. The horizontal line from P is the demand curve of the firm. The firm produces amount OA. It does not produce more because additional output has a cost higher than the price. For any output larger than OA, MC exceeds price. Figure (c) shows an unprofitable price for the firm. The price is below the firm’s full costs. But he firm produces amount OA, whose marginal cost equals the price OP. At this price the firm’s net revenue is PC. It shows that a firm in a perfect competition market operates at a loss because the net revenue is less than fixed costs. Hence the economists make use of the short run equilibrium curves to arrive at a conclusion about the most important points that the firm can produce in order to maximize profits. In the long run industries do grow; new firms enter growing industries adding their new capital to the expanding stock of the capital of the firms already in the industry. Some industries decline, firms leave, and the stock of the industry declines. In the long run, the behaviour of the industry is the collective behaviour of the firms. Hence the individual firm must first be put under analysis. The objective of the firm in the long run is to maximize its net profits, the excess of revenue over full cost. The firm doers this by adjusting output so that LMC = price. It is vital to note that when all the firms in the industry are earning net profits, other firms will be attracted to the industry. Ceteris paribus (other things constant) the added output from the new firms lowers the price. As the price falls, the net profits of the firms, both old ones and the new comers diminish. When the price equals minimum average costs, net profits are zero because all the firms are earning normal profits, which by definition are large enough to keep the firms in the industry. Normal profits of course are included in the costs curves. Price Pii LMC Long run Equilibrium of the firm. Pi LAC P = MR = LMC = LAC O A B Quantity The entry of new firms lowers the price as in the figure above. If the price goes below OPi the firm continues to produce in the short run provided that the price is higher than average variable cost. But in the long run, the firm will not produce at a price below OPi because any such price does not cover full cost. The price OPi is equal to marginal cost and also to the minimum average cost. And since price is the same as marginal revenue to a firm under perfect competition market then P = MR = LMC = LAC. This analysis of the long run equilibrium of a firm in the perfect competition market helps in making wise decisions as to the most important point of production. Question three A monopoly is a market situation where there is only a single firm in the market where there are no close substitutes, and in making his decision on price the monopolist in independent. He does not have to allow for the price, policies of other sellers. He does not have to take other prices into account because they as always, help to determine the demand for his product. There are several cases when the existence of a monopoly may be justified. First, when a firm controls an important factor of production. This makes the firm to stand uniquely in the market because it is the only firm that can be able to produce the output using the factor of production it owns. Second, when the government one to properly distribute and use an important public resource such as oil, rail transport, power to mention few, a single firm can be established that deals with production and distribution of such important resources. Third, is economies of scale. If the industry in which a firm is producing has a very high fixed cost, the consumers benefit a lot from firms that are large enough to exploit economies of scale. Economies of scale results into lower average costs which in turn results into lower prices. Industries such as car production and airline production are examples of industries which have economies of scale. Fourth, research and development. Firms that have monopoly profits use their profits to invest in new technologies and products that help consumers in the long run. For example, an oil company that finds new sources of oil takes time to conduct research on various issues surrounding the product. Fifth, firms with monopoly power are efficient. Firms with monopoly power are innovative, invariably successful and efficient. Question four The power of a monopolist may be reduced through regulation. Two methods of regulation namely behavioural regulation and structure regulation can be distinguished in reducing the monopoly power. Behavioural regulation, aims at determining the monopoly behaviour in order to channel its changes to the society’s interest. This can be done through policies against anti-competitive behaviour, environmental regulations and price regulation. Structure regulation aims at changing the structure of the organization in the industry in order to make it similar to the needed structure for aggressive behaviour. The government should regulate the power of the monopoly in order to prevent the failures in the market associated with it which may be against the interest of the public. Behavioural regulation is applicable when the firm’s long run average curve (LRAC) is flat bottomed while structure regulation is applicable when the firm’s long run average curve is U-shaped. Monopoly regulation in normal cases requires a combination of the two. Question five Imperfect competitive industry is a competitive situation in nay market where necessary conditions for perfect competition are not satisfied. There are several forms of imperfect competition namely, oligopoly, monopoly, monopolistic competition, oligopsony and monopsony. Some other reasons that may necessitate the emergence of imperfect competition include sellers or buyers lacking information about the goods being traded and prices in the market. (Selin, 2002) Price Demand and marginal revenue of a firm in An imperfect competitive industry. B P D MR O A Quantity A rise in demand results in increase in price. However, in an imperfect competitive market if the demand increases he does not necessarily raise his price. If the marginal cost is falling he would lower his price when demand increases so long as the new quantity of marginal cost and marginal revenue is compatible with lower price. This can be illustrated using the diagram below. Price and cost AC diii di Quantity The aim of the firms in an imperfect competive market is to maximize profits. Maximum profits in the long run and maximum net revenue in the short run. If the demand increases prices rise. If the demand increases above the average cost curve for example, diii, then the firm in an imperfect competitive market will make super normal profits. As a result the production will also be raised beyond the normal production level in order to seal the production gap that may have brought up the demand. The high profits enjoyed by the firms in an imperfect competitive market attracts new firms in the industry which results into increased supply of goods in the market resulting into the demand curve dropping back to the tangent between the average cost curve and demand curve as shown above. At this point the firms will be making normal profits. (Leo, 2004) Question six As mentioned above, increase in demand results into increase in price so long as the marginal cost of producing an additional unit of output is increasing. The increase in price results into increased amounts of profits which in turn attracts many more firms into the industry. If however, barriers to entry are allowed to exist then it means that the firms already in the market will continue enjoying the super normal profits. Profits realized due to increase in demand above the average cost curve as shown above. Hence if barriers to entry are set it means that firms in an imperfect competive industry sets prices to maximize their revenue in the short run and maximize profits in the long run. If costs of production increases firms raises their price by less than the unit rise in cost. With linear demand and constant cost assumptions output of firms in an imperfect competive industry in long-run equilibrium is half the competitive. The theory of imperfect competitive pricing is applicable mostly in business and in evaluation of public-utility regulation. REFERENCES Henry, K. (2002) economics of firms, New York, Macmillan Publishers Leo, G. (2004), market structures, Harvard, Harvard University Press. Selin, H. (2002), demand in imperfect competive market, New York, McGraw Hill Publishers Read More