Market Structure in Micro Economics - Research Paper Example

Market Structure Contents Introduction 2 Discussion 2 Perfectly Competitive Market Structure 2 Characteristics of Perfectly Competitive Market 2 Price output Decision in Perfect Competition 3 Monopolistically Competitive Market Structure 5 Characteristics of Monopolistically Competitive Market 5 Price output Decision in Monopolistic Competition 6 Oligopolistic Market Structure 7 Characteristics of Oligopoly Market 7 Price output Decision in Oligopoly 8 Monopoly Market Structure 9 Characteristics of Monopoly Market 9 Price output Decision in Monopoly 10 Economic Efficiency in Market Structure 13 Efficiency in Perfect Competition 13 Efficiency in Monopolistically Competitive Market and Oligopoly Market 13 Efficiency in Monopoly Market 14 Reference List 15 Introduction Market Structure is an imperial study in Micro economics that may be defined as a collection of interdependent factors which determine the level of interaction between buyers and sellers prevailing in the market and adjust price and output level according to the interrelationship between them. In particular, market structure demonstrates the number of firms producing identical and homogeneous goods and services. Perfectly competitive market, monopolistically competitive market, Oligopoly market and Monopoly market are the four distinct market structure prevailing in the economy (Hirschey, 2008). The key constituents of Market Structure can be attributed as the number of firms operating in the market (concentration ratio), degree of economies of scale, vertical integration of production and distribution channels, product differentiation as well as consumer turnover ratio. The structure of the market can be determined through analyzing certain features such as the number of buyers and sellers present in the market, scope for product substitution, degree of entry and exit barriers and mutual interdependence of buyers and sellers (Mankiw, 2014). In this paper, the fundamental characteristics of each market will be analyzed and their price output determination in short run and long run will be evaluated. Discussion Perfectly Competitive Market Structure A market structure is said to be perfectly competitive if the market is characterized by large number of participants producing homogeneous goods. Characteristics of Perfectly Competitive Market In a perfectly competitive market, a large number of buyers are willing to buy products and services at a certain price level and a large number of sellers are willing to sale those products and services for the specified price level. All firms are price taker in perfectly competitive market, having a relatively small market share and operating in a profit maximization motive. Profit is maximized in that point where marginal revenue meets marginal cost (Stackelberg, Bazin, Hill and Urch, 2010). There are no barriers to entry and exit for firms into the industry. All factors of production are perfectly mobile in long run perfect competition. Complete information is available to the consumers in terms of product quality, method of production, price of competitors. Purchasing behaviour of the buyers is rational as all information is available to them. Market cannot be affected by any externalities. Buyers are well aware about their market rights. Therefore, no cost of benefit can influence one party to harm the other party. Firms are engaged in producing homogeneous goods which are hardly differentiated in terms of price level and quality. Economies of scale is absent in this market structure as a result of continuance of a large number of buyers and sellers. There is no transaction cost is perfect competition. Hence no cost is involved in exchanging goods in this type of market structure. Local fish or vegetable market is a perfect example of this kind of market structure (Stackelberg, Bazin, Hill and Urch, 2010). Price output Decision in Perfect Competition Short Run Phenomenon Figure 1: Short Run Equilibrium in Perfect Competition In short run perfect competition, all firms are price taker, operating in a profit maximization motive. Seller must go with the existing market price as charging a price higher than market price will lead to loss of potential buyers for the firm and charging higher price will result in reduction in profit level. Marginal cost differs according to the quantity produced. Hence, firms will strive for increasing inputs to the level where marginal cost is equal to price level and profit is maximized where marginal cost intersects the market price. However, firms will tend to produce till the average variable cost is lower than market price. As a result, most of the firms experience abnormal profit in short runs perfectly competitive market (Stackelberg, Bazin, Hill and Urch, 2010). Long Run Phenomenon Figure 2: Long Run Equilibrium in Perfect Competition In long run, it becomes necessary for all firms to recover all types of cost involved in production process. The supernormal profit earned by the existing firms in short run attracts more and more firms to enter the industry and it provides the firm a huge scope for expansion of output. Such effort by the firms relocate the existing resources as they are perfectly mobile and shifts the market supply curve outward, to the right. If the market demand is constant, increase in market supply will lead to reduction in market price. In this situation, the firms will continue to produce until price level becomes identical to long run average cost. At that particular point, long run equilibrium holds in perfect competition. At equilibrium, firms experience normal profit at profit maximizing output (Machovec, 2002). Monopolistically Competitive Market Structure In monopolistically competitive market, imperfect competition arises as large number of producers tends to produce slightly differentiated products with limited or no information about competitors’ demand, supply and price level (Feenstra, 2010). Characteristics of Monopolistically Competitive Market In monopolistically competitive market, existence of large number of small firms can be seen. One firm’s decision regarding setting up price level and output is not influenced by the decision made by other firms. Hence, if one firm reduces its price of output for increasing sales, immediate action of price cut is not experienced by the competitor firms in this market structure. Firms are engaged in supplying slightly differentiated product. However, the degree of differentiation is negligible; hence consumers’ decision of selecting or eliminating competitors’ product is not influenced by such differentiation. Products produced in monopolistically competitive market have close substitutes. Hence positive cross price elasticity of demand is experienced in the market. Entry of large number of small firms signifies requirement of very low start-up cost in this market segment. However, inability of many of those firms to incur sufficient profit in long run to cover their fixed cost leads the firms to go out of business. Hence, the market is characterized by no entry, exit and sunk costs. Firms in monopolistically competitive market are engaged in independent decision making, giving less or no emphasis of competitors’ decision. Firms adjust their price- output ratio for the purpose of achieving their own targeted level of profit. As the firms in monopolistically competitive market are capable of changing their price level without losing their prospective and existing customer base, they enjoy positive market power. Such market power arises due to few existing firms’ ability to sell slightly differentiated products in the long run; making the firm’s demand curve downward sloping and highly elastic. Monopolistic competition is exercised mostly in street side fast food restaurants ((Stackelberg, Bazin, Hill and Urch, 2010). Price output Decision in Monopolistic Competition Short Run Phenomenon Figure 3: Short Run Equilibrium in Monopolistic Competition In a monopolistically competitive market many conflicting factors contributes to increase the total revenue. Price level may be reduced to attract more consumers and increase the quantity sold but in the time of doing this, firms should also calculate the profit foregone which could have been achieved through selling of goods at a higher price. Therefore, profit is maximized through adjusting price and output till the marginal revenue intersects marginal cost. Profit is maximized where MR is equal to MC, determining equilibrium level of price and output at P and Q respectively. Opportunity for supernormal profit is marked by the area CBAP. However, as new firms start entering the market, the demand for the products of existing firms becomes more elastic, shifting the demand curve rightward by lowering price level. As a result, all the supernormal profits abolished (Nadala and Vannimenusa, 2005). Long Run Phenomenon In long run, monopolistically competitive market reacts similar to the perfectly competitive market apart from dealing with heterogeneous products. New entrants shift the demand curve upward, eroding the opportunities to earn supernormal profit. Clearly, firms are benefited in short run only (Nadala and Vannimenusa, 2005). Figure 4: Long Run Equilibrium in Monopolistic Competition Oligopolistic Market Structure Oligopoly is a market structure in which the industry is dominated by a small number of firms. Characteristics of Oligopoly Market Oligopoly market is characterized by high interdependence in decision making among the existing firms into the market segment. Hence, slight change in price level of one firm leads to prompt action taken by competing firm because such action taken by one firm will directly affect the price and output of other firms, as few firms exist in the market. In order to maximize their profit, firms under oligopolistic market are engaged into cut throat competition for capturing more market share than its competitors. Hence, promotional activities such as advertisement and sales promotion hold enormous importance for the firm in oligopoly market. Price level is very rigid in oligopolistic market structure. Reduction in price level of one firm leads to immediate price cut of rival firms. Hence, firms in oligopoly market, engage in very frequent price war. As a result, each firm calculates the anticipated price output decision of competing firms before altering its own price level for the purpose of increasing sales (Puu and Sushko, 2002). In oligopoly market, together the firms act as a single unit by producing differentiated products and by regulating price and level of output for profit maximization. Hence, the firms act as monopoly together in oligopoly market (Stackelberg, Bazin, Hill and Urch, 2010). Interdependence among firms in oligopolistic market structure leads to suspicions regarding demand for products. Hence, demand curve cannot be determined in short run as there is no definite relationship between price and output into the industry. Moreover, firms are also incapable of predicting pricing decision of their rivals as a result of changing their own price level. OPEC (Organization of the Petroleum Exporting Countries) is the most significant example of oligopoly market structures that controls export of petroleum in international market (Puu and Sushko, 2002). Price output Decision in Oligopoly Figure 5: Equilibrium condition in Oligopoly Market The individual demand curve in oligopolistic market is more elastic as compared to the market demand curve as there is a strong propensity among firms to collude for capturing more market share. Hence, a reduction in price level will only attract those customers who are not reluctant to buy at a higher price; apart from their existing customer base. Hence, short run demand curve cannot be established as there is no definite relationship among demand and supply due to uncertainties in market. In long run, price level and output is determined where marginal cost intersects long run marginal revenue (Ishida and Matsumura, 2011). Monopoly Market Structure Monopoly is a market structure where a single firm supplies products and services to the consumers in the market. Various government agencies promote monopoly especially in telecommunications and electricity departments. Characteristics of Monopoly Market Monopoly market is characterized by a single supplier supplying unique products and services. If a firm has the ability to control more than 25% of the market, the firm is said to have monopoly power. Therefore, the level of competition for the firm is almost negligible as it is the sole supplier of the particular product or services with no close substitute. Here, the supplier is price maker. In monopoly market, entry and exit of firms is restricted. As a single firm controls the market, the concept of firm and industry is identical in monopoly situation. The average revenue of monopoly firms is always greater than its marginal revenue. Being the dominant firm in the industry monopoly enjoys definite market power of reducing price in order to increase sales. In general, monopoly firms obtain the benefit of profit after recovering its fixed cost in the long run only as the establishment cost is huge for initiating monopoly in the market. However, such profit may result in abnormal gain due to absence of competition and for acquiring power of controlling the whole industry. In short run, the loss experienced is equal to the fixed cost of the firm. In fact, in case of a low demand industry, establishment of monopoly will lead the firm to suffer continuous losses and drive to go out of business. The demand for monopoly products and services being less elastic, the market demand curve is downward sloping. As the monopoly firm controls the supplies itself, price movement is automatically adjusted. Hence, increase in price level leads to decreasing in quantity sold, thus making the demand curve to be downward sloping. Monopoly firms are capable of charging different prices to different customer segments for same product which is known as price discrimination. Dumping i.e. charging a higher price in international market and comparatively lower prices in domestic market for same goods is a common form of price discrimination that monopoly firms practice in international trade (Stackelberg, Bazin, Hill and Urch, 2010). Price output Decision in Monopoly Short Run Phenomenon Figure 6: Short Run Equilibrium Condition in Monopoly Market In short run, monopoly firms adjust the output by controlling price level. Hence, equilibrium is achieved when marginal cost intersects marginal revenue and the short run marginal cost curve cuts short run marginal revenue curve from below. As the demand is not definite to the monopoly firms, optimal price and output is determined at the profit maximizing equilibrium position (Nadala and Vannimenusa, 2005). Figure 7: Long Run Equilibrium Condition in Monopoly Market Monopoly firms earn supernormal profit in the long run. Profits are maximized where MR= MC holds. At that equilibrium point, price and output are determined at P and Q correspondingly. If the price level remains above average total cost curve, firms can access supernormal profits (Erikson, 2014). Economic Efficiency in Market Structure Economic efficiency is achieved under each market structure. Economic efficiency is of two types: Productive Efficiency which arises when goods are produced at a lower possible cost aligning with production possibility frontier and Allocative Efficiency that leads to distribution of allocated resources for benefit of the society as a whole (Cohen, 2010). Figure 8: Economic Efficiency and Production Possibility Frontier Efficiency in Perfect Competition In perfect competition, both consumer and producer surplus are maximized as no firm has the option to better off by deteriorating the position of other parties. Hence, Pareto optimal allocative efficiency is established in equilibrium position where price is equivalent to marginal cost. Productive efficiency is attained in long run when equilibrium output is defined at the minimum point of LRAC (Mankiw, 2014). Efficiency in Monopolistically Competitive Market and Oligopoly Market In a monopolistically competitive market, firms struggle to set price higher than the marginal cost; hence, it is impossible for such firms to become productively efficient and to achieve allocative efficiency. Considering Oligopoly market, firms involved in this market segment produces neither in a cost effective way nor in the proper quantity according to societal need. Further, optimal price is achieved in oligopoly market where output is below to the point at which minimum average cost curve is achieved. Hence, oligopoly market as well fails to stimulate economic efficiency (Mankiw, 2014). Efficiency in Monopoly Market Economic inefficiency in monopoly market is a reflection of the ability of monopoly firms to incur supernormal profit and practice market power. Allocative efficiency does not arise in monopoly as the higher price is extracted 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. Conclusion After analyzing market structures engaged in the micro economics, their characteristics, equilibrium conditions and economic efficiency associated to the markets, it can be concluded that a firm should consider the market size, industry performance, existing market players and nature of competition prevailing in a market and accordingly decide on the market category that will be best suitable for its business establishment and expansion. Selecting market on the basis of these economic criteria will definitely lead the firm to experience sustainability and long term profit in business operations (Cohen, 2010). Reference List Cohen, W., 2010. Fifty Years of Empirical Studies of Innovative Activity and Performance. Handbook of the Economics of Innovation (I), 1(2), pp. 129–213. Erikson, E., 2014. Between Monopoly and Free Trade. New Jersey: Princeton University Press. Feenstra, R., 2010. Measuring the gains from trade under monopolistic competition. Canadian Journal of Economics, 43 (1), pp. 1-28. Hirschey, M., 2008. Managerial Economics. Boston: Cengage Learning. Ishida, J. and Matsumura, T., 2011. Market Competition, R&D and Firm Profits in Asymmetric Oligopoly. The Journal of Industrial Economics (I), 59 (3), pp. 484-505. Machovec, F., 2002. Perfect Competition and the Transformation of Economics. London: Routledge. Mankiw, N., 2014. Principles of Economics. Boston: Cengage Learning. Nadala, J. and Vannimenusa, J., 2005. Multiple equilibriam in a monopoly market with heterogeneous agents and externalities. Journal of Quantitative Finance (I), 5 (6), pp. 557-568. Puu, T. and Sushko, I., 2002. Oligopoly Dynamics: Models and Tools. Berlin: Springer Science & Business Media. Stackelberg, H., Bazin, D., Hill, R. and Urch, L., 2010. Market Structure and Equilibrium. Berlin: Springer Science & Business Media. Read More