Price Theory and Applications - Essay Example

?Running Head: MARKET STRUCTURE School: Topic: Market Structure Lecturer: presented: Q1: Perfectly Competitive Market There is different market conditions under which firms sell goods and services referred to as market structures. These describe the main aspects of markets such as the products sold, the number of firms, and ease of entry and exit. The different market structures include: perfect competition, monopoly, monopolistic competition, and oligopoly. A perfectly competitive market is characterized by various features which in most cases are not found in a real world but are used as benchmarks for other markets. According to Baumol and Blinder (2011 p. 200), such a market must satisfy four conditions. First, the market has many small firms and customers such that no participants are large enough to have market power to affect the price of a product. If one producer reduces the price, there would be no effect on the market since the producer is negligible compared to the whole market. This condition rules out the possibilities for collusion or trade associations; each firm acts independently (Tucker, 2010). Secondly, all the suppliers sell a homogeneous product; there are no close substitutes (McEachern, 2011). As such, the consumers buy products from any seller since the products are the same thus competition is very powerful. The demand curve is perfectly elastic hence if a seller increases the price of the product, customers shift to buy competitors products. The firms have no choice but to meet and not exceed the price charged by others hence are “price takers” (Baumol & Blinder, 2011 p. 201). Thirdly, there are no barriers to entry or exit in the market. Barriers to entry may be in form of legal, technical or cost advantage but in a perfectly competitive market, any seller willing to enter the industry can do so to take advantage of economic profits and provide an identical product (p. 200). The new entrant is at the same level with the old firms; there are no advantages for existing firms so the new firm can compete effectively. Lastly, the infinite buyers and sellers have perfect information regarding the price and quality of products in the market. As a result, there is no need for advertising as it would have no effect; the customers know where to buy their products and besides, all products are identical and the price is determined by the market. According to Landsburg (2011), in a perfectly competitive market there are no transaction costs and perfect factor mobility. This enables the market to adjust accordingly in case of changing market conditions. Q2: Price and Output Decisions of a Perfectly Competitive Market As noted above, there are infinite buyers and sellers in the market such that none has an effect on price. The price in such a market is determined by forces of supply and demand hence the sellers are “price takers”. Sexton (2012) argues that since the market price is given, the only decision that firms have to make is determining the level of output that would maximize profit. The question firms should ask themselves as asserted by McEachern (2011 p. 176) is “how much should I produce?” He notes that firms aim at producing a quantity at which total revenue is higher than total cost by the greatest amount. The profit maximizing output in a perfectly competitive market occurs where marginal revenue (MR) is equal to marginal cost (MC); MR=MC therefore the firms are seen to allocate resources efficiently. A perfectly competitive firm has a horizontal demand curve thus it can sell as much quantity as it wants at the given market price. Whether the firm increases its output or not, the price remains the same as there are many sellers. It also does not have to reduce the price so as to attract demand as it would lead to loss of revenue for the firm (Baumol & Blinder, 2011). Since total revenue is the output multiplied by the price, the average revenue is the same as price. The firm is also a price taker hence the marginal revenue is equal to price; P=MR=AR. The profit maximizing output occurs where MC=MR thus P=AR=MR=MC. In the short-run, firms can make an economic profit where price is greater than average cost but in the long-run the firms make zero economic profit as new firms enter the market and compete away the profit as there are no barriers to entry. Q3: What is Monopoly? A monopoly is at the other extreme opposite of perfectly competitive market. A pure monopoly is characterized by the existence of a single firm in the industry, lack of close substitutes for the monopolist’s products, and impossible entry barriers (Tucker, 2010). The source of a monopoly is the existence of barriers to entry and cost advantages which make smaller firms unable or unwilling to compete in the market. These barriers and cost advantages include: legal restrictions, patents, copyrights, ownership of a vital resource, economies of scale, and large sunk costs. The legal restrictions are imposed by the government so as to control the scarce resources especially in some geographical areas although some are national monopolies such as the US postal service. Water and sewer services as well as natural gas may also be monopolised so as to provide essential services to customers at a lower cost. To encourage inventions and innovations, the inventors are given patents or copyrights hence exclusive production rights for a period of time thus creating a monopoly (Tucker, 2010). A monopoly may also be necessitated by ownership of a strategic or rare input by a single seller making it impossible for others to engage in production of that product. Large businesses enjoy economies of scale that would force new firms out of the market since they incur a lot of costs. Some businesses require huge investments to establish and expenditure is recovered only after sales are made in future. This acts as a natural barrier to entry as few firms would risk such huge sunk costs (Baumol & Blinder, 2011). Other monopolies may result from technological advancements or as a result of deliberate efforts by a monopolist to prevent new entrants in the industry. Q 4: Determination of Price and Output in a Monopoly Market Since the monopolist is a single seller in the market and there are no close substitutes to his product, he has the discretion to set the product’s price. Unlike in perfectly competitive markets where a seller is a price taker, as Sexton (2012) puts it, a monopolist is a price maker since he can decide to raise or reduce price. However, the monopolist can only set the price but cannot determine the quantity as it depends on consumer demand; the higher the price, the less the quantity consumers will buy but in case of monopoly not all business is lost. Customers buy the product because it is only available from one seller but in low quantity. The demand curve for a monopolist is therefore downward sloping. The marginal revenue curve is below the demand curve (Average revenue curve) therefore, MR is always less than price. The profit maximising output is where MR=MC and the height of demand curve at that output gives the price (Baumol & Blinder, 2011 p. 222). Q5: Compare and Contrast Outcome in Terms of Output and Prices in Perfectly Competitive Market and Monopoly As stated earlier, firms in a perfectly competitive market are price takers while monopolists are price makers. Another notable difference is that there infinite sellers in a perfect market and a single firm in a monopoly hence the monopolists is able to manipulate price and quantity to serve his interests but in perfect competition a firms decision has no effect as it is negligible. In this case, a monopolist can restrict output in order to raise short-run price and make more profit leading to inefficiency in resource allocation (Landsburg, 2011). Another difference that affects price and output decisions in the two markets is that there are no barriers to entry and exit in a perfect market hence in the long-run; firms incur zero economic profits whereas profits for a monopolist can persist (Baumol & Blinder, 2011). The outcome is that a monopoly market produces low output and sells at high prices whereas a perfectly competitive market produces high output and sells at low prices than monopoly. Q6: Monopolistic Competition Monopolistic competition is between the two extreme ends of a perfectly competitive market and a monopoly market. The market under monopolistic competition therefore, has characteristics of both markets but is much more like a competitive market than a monopoly. The market is characterised by many buyers and sellers such that ach firm’s output is negligible in comparison to total output. However, unlike in a perfect market, firms sell similar but not identical products hence each firm is a monopoly (Tucker, 2010). For example, there are various restaurants in an area but each firm sells different products whether real or as perceived by customers. Just like perfect competition, there are no barriers to entry or exit thus each firm incurs zero economic profits in the long-run as profit is competed away by new entrants. The participants in the market also have perfect information regarding the products and therefore, can make purchase decisions easily. Due to product differentiation, there are no perfect substitutes hence just like in a monopoly increasing price would not lead to zero output but there would be loss of considerable business hence the demand curve is negatively sloped but flatter than that of a monopolist (Sexton, 2012). Q7: Product Differentiation Sexton (2012) views product differentiation as having unique products with many close substitutes or selling similar but not identical brands such as tooth pastes, books, and restaurants. This enables the sellers in a monopolistic competition to have market power to influence prices of their products. As Sexton puts it, the difference between products may be real or perceived (2012, p. 401). Some buyers have a tendency of believing that the products sold by different sellers are not the same although in reality they are the same; it may be the same item but in a different package. Q8: Ways of Differentiating Products by Monopolistic competition firms According to Sexton (2012), there are various ways in which firms differentiate their products so as to make them unique and attract customers. One way to differentiate products is through packaging. Many sellers in a monopolistic competition offer same products but put them in different packages hence they appear different. The packages can be attractive, portable, among other features so as to capture buyers; for example, cookies or different toothpaste brands. Some products differ from seller to seller in terms of quality. This is especially so for restaurants and electronic items. The difference can also be physical such as difference in tastes or different brands of athletic footwear. Other firms differentiate in terms of service delivery or supplementary services; most customers prefer speedy, friendly, and quality delivery. Firms may also differentiate in terms of location or by making the store look appealing to customers. Instead of customers travelling to far places to buy similar items, the firm can locate the business in a strategic place with beautiful sceneries hence differentiate the firm from other businesses. Some firm’s products are regarded as prestigious by customers such as the Rolex watches hence creating a name for itself and developing brand loyalty. The firms in a monopolistic competition unlike in a monopoly or perfectly competitive markets need to engage in mass advertisements in order to differentiate their products and attract new loyal customers or otherwise lose to competitors (Sexton, 2012). References Baumol, W., Blinder, A. (2011) Economics: Principles and Policy. 12th ed. Mason, OH: Cengage Landsburg, S (2011). Price Theory and Applications. 8th ed. Mason, OH: Cengage McEachern, W. (2011). Economics: A Contemporary Introduction. Mason, OH: Cengage. Sexton, R (2012) Exploring Economics. 5th ed. Mason, OH: Cengage Tucker, I (2010). Survey of Economics. Mason, OH: Cengage Read More