A Comparative Analysis of Four Major Market Structures - Term Paper Example

Market structures determine the behavior of the participants of a market. There are different market structures that affect the way a business operates in terms of strategic options such as pricing strategy, long term position, reaction to other participants, and entry position among other variables. The four major market structures are perfect competition, monopolistic competition, oligopoly and monopoly. This paper focuses on perfect competition by examining the pro and cons, strategic alternative, pricing policy of firms participating in this market and it provides a comparative analysis of all four major market structures. A barrier of entry is a constraint that limits the entrance of new competitors into an established marketplace. Barriers of entry variables include cost advantages, high capital requirements, patents, sunk cost implications and research and developments expenditures (Tutor2u, 2007). A market structure that has limited barrier entry imposition is the perfect competition market. The lack of existence of barrier of entry means that the marketplace can be penetrated by many suitors, thus the quantity of business is high. Competition is fierce is this market structure. Economists that describe perfect competition as the ideal market are influenced by the lack barrier entry characteristic as one of their main arguments for the claim. The perfect competition market structure has other characteristics that make this market unique. Other major characteristic of perfect competition are product homogeneity, perfect dissemination of information, and both sellers and buyers are price takers and product differentiation strategic focus among similar products (Hirschey, 2006, p.319). Homogeneity is characteristic which implies there is similarity in the product or output of the good or service sold by the companies (Dictionary, 2007). The dissemination of information means that the market immediately allows clients or investors to gain access to any new information about the companies or products in the marketplace. No one company can gain a competitive advantage from specialized information such as patent knowledge in monopoly markets. Product differentiation is a strategic move utilized by players in this industry to create a real or perceived difference in the product (Hirschey, 2006, p.321). An example of a product differentiation application can be spotted in cereal products. Kellogg’s Frosted Flakes enjoys a branding recognition which differentiates the product from other cereals and allows the company to allocate a higher price for its branded product. A company that is part of a perfect competition market must rely and form financial models and strategic decision based on the equation marginal cost equals price which equals marginal revenues (P=MC=MR). The implication of this equation is that cero economic profit is achieved in the long run for a firm in a perfectly competitive market. Appendix A shows a graphical illustration of a firm supply curve and its marginal cost curve under perfect competition. The graph illustrates the equality of the supply cost curve and its marginal cost curve when a shift in price shifts the quantity. Maximizing profit in this structure is not dependant of profits per unit, instead total accumulative profits are the objective irrelevant of lower profits per unit of output (Colander, 2004, p.248). Appendix B illustrates graphically the profit determination in a perfect competition market. The graph shows how a person can determine if a firm is either sustaining profits, losses or cero gain. The way to figure out the amount of monetary profits is by a person dropping down a line from the MC = MR intersection point which represents the profit maximizing quantity to the average total cost curve to determine the price to achieve that quantity. The result of the multiplication of the quantity of the MC=MR curve by price of the ATC curve is the total profit or loss of the company. Appendix C shows the long-run equilibrium effect of firm’s in a perfect competition market structure. Increases in demand in the short run shifts the short run demand curve to the right as shown in the left graph of the appendix, but the long run effect is an idle price equal to the original price with a different overall output of greater magnitude. One of the best examples of applications of perfect competition in the real world is the New York Stock Exchange (NYSE). Stock exchanges such as the NYSE happen to be auction based firms. The NYSE belongs to the stock market industry. In this industry all stock market perfectly compete in the business of selling the homogenous service of facilitating transactions of buying and selling financial assets such as common stocks. A new rule imposed by the Securities and Exchange Commission (SEC) on 2006 following a wave of merger transactions in the stock exchange industry created further enhancements to this perfect competition market structure by forcing brokers on the floor of the exchanges to obtain the best price available for the purchase or sell transaction in the stock exchange the professional is working or any external stock exchange. A perfectly competitive market such as the stock market provides buyers and sellers of stocks price instant price adjustments in the price of common stocks due when new information about a company is made available. No one gains any competitive advantage from a piece of information since everyone has instant access to any new information about a particular investment option. A second economic market structure is monopolistic competition. The market structure has the following characteristic: many sellers, differentiated products, easy entry of firms in the long run and different dimension .The key characteristic that makes this structure different from a perfect competition model are product differentiation and dimensions of competition. Products of firms in this market structure are different. For example Burger King and Kentucky Fried Chicken compete in the fast food industry, but one sells chicken and the other sells burgers. A firm must put greater effort into other business dimensions such as marketing, production, distribution and research and development to achieve a competitive advantage. The profit optimizing equation in monopolistic behavior is the same as in perfect competition, but the interpretation of the graphs is different. The demand curve in monopolistic competition is downward sloping as illustrated in Appendix D. The implication of the downward sloping curve is that while perfect competition has equality of MC=MR=ATC, in monopolistic behavior the ATC is not equal to the marginal cost. The downward sloping curve also means that there are economies of scale associated with higher production volumes and higher market share is a strategic choice for firms in this market structure. A third type of economic market structure is an oligopoly. An oligopoly is a structure in which there is a limited amount of players competing against each, which is the opposite of a perfect competition structure because perfect competition has many sellers. The firms in oligopoly compete against each other, but are conscious of the other company’s moves and prefer cooperation than intense battles such as price wars (Griffiths & Wall, 2005). Game theory is associated with the strategic choices of firms in oligopoly. Barriers of entry exist in oligopoly (Varian, 2003). The relationship between marginal cost and price is different in oligopoly in comparison with perfect competition. In oligopoly marginal cost is greater than price, while in perfect competition price equals marginal cost (Colander, 2004, p.303). Economic profits can are attainable in the long run in an oligopoly market structure. The final major economic structure is monopoly. Monopoly occurs when only one firm control the marketplace, thus competition is non existent. A monopolist can achieve economic profits in the long run since the firm controls more variables than in other markets. The monopolist restrict overall output to find the price that reaps greater benefits for a firm. Since the monopolist marginal revenue is below its price equilibrium output is different than in a competitive market such as perfect competition. There are barrier of entry associated with monopoly. An example of a way a company can achieve a monopoly is market is through innovation. A company that is awarded a patent for an invention obtains exclusivity to produce a product of service for 17 years. A company that created a monopoly market in 2005 with a patent award is Papyrus Australia. This firm created a method to produce paper out of banana trucks called banana ply paper. Comparative Analysis of Economic Structures The four economic market structures differ from each other in many ways. Appendix E shows a tabulation of some characteristics of the different economic structures. Perfect competition has peculiar characteristics which make it the ideal economic structure. There is a lack of barriers of entry in perfect competition, a variable not available in monopolies and oligopolies. In monopolistic competition companies have to utilize many strategies due to the different competitive dimensions, while in perfect competition the strategic decisions for the managers or owners are simpler. The information asymmetry in perfect competition allows both sellers and purchasers in perfect competition to obtain the information necessary to make decision in real time and instantly. For example a person shopping for a new car can not be persuaded by lies from a salesperson since an educator buyers can enter the internet and obtain all the relevant information about a particular car model and the competition. “The internet has had its biggest impact on firm’s buying practices” (Colander, 2004, p.243). Price is a key factor that determines which firms will be successful in perfect competition. In a monopoly the customer has no options and must pay whatever price the firm decides to charge for a product, this constraint is not existent in perfect competition. The fact that price is driving variable simplifies the selling and purchasing alternatives for the stakeholders involved in a perfect competition marketplace. The lower the price the more attractive a product or service becomes for the purchasers in a competitive marketplace. Conclusion A firm that seeks to establish a business must consider the market structure the potential business belongs too. A person or organization can have infinite economic resources, but this does not necessary mean the person can penetrate any desired marketplace. If there is monopoly market establish nobody can enter the market due to reasons such as regulatory status, patents rights, specialized expertise to enter a market, unbreakable cost structures achieved through many years of accumulating experience. An economic market structure that is simple and allows entrepreneurs to establish a business with relative ease is perfect competition. Perfect competition has advantageous characteristics such as low barriers of entry, information asymmetry, and a large amount of potential customers for a business; characteristics which make perfect competition the ideal marketplace. References Colander, D. (2004). Economics (5th ed.). The McGraw-Hill Companies. Dictionary.com (2007). Homogeneity. Available from [Accessed 21 November 2007]. Griffths and Wall (2005). Economics for Business and Managers (1st ed). Market Structures Part A. Pearson Education Limited. Griffths and Wall (2005). Economics for Business and Managers (1st ed). Market Structures Part B. Pearson Education Limited. Hirschey, M. (2006). Economics for Mangers (India Edition). Australia: Thomson South-Western. Tutor2u.net (2007). Barriers of Entry. Available from [Accessed 22 November 2007]. Varian, H.R. (2003). Intermediate Microeconomics: A Modern Approach (6th ed.). New York: W.W. Norton & Company. Appendix A: Supply Curve and Marginal Curve: Perfect Competition (Griffths and Wall, 2005). Appendix B: Lost, Gain, Breakeven Under Perfect Competition (Colander, 2004, p.251). Appendix C: Long run equilibrium under perfect competition (Colander, 2004, p.256). Appendix D: Perfect competition vs. Monopolistic Competition (Colander, 2004, p.292) Appendix E: Economic Market Structures Comparison Perfect Competition Monopoly Monopolistic Competition Oligopoly Example firm NYSE Local utility KFC Delta Airlines Barriers to entry No Yes No Yes Numbers of firms Plenty One Plenty Two or more Price elasticity of demand Perfect None High Medium Economic profits Price=MR=MC MR=MC P=MC=MR Possible with use of game theory Read More