Market Structure


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Market Structure Detailed Notes

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Market Structure

  1. 1. Perfect Competition: 1. Large number of buyers and sellers:In this market structure there are large number of buyers and sellers e.g. many farmers growing wheat. If one of them, produces more or less that will not affect the market supply or the market price. In this there are large buyers also. Even the buyers cannot influence the price by changing their demand because each buyer and seller is like a drop in ocean 2. Homogeneous product:It is the most important feature. It says that the product which these large number of buyers buy from large number of sellers are identical or we can say perfect substitute that means, if one buyer increase the price the buyer will buy it from other seller as the products are identical e.g. rice. 3. Free entry and exit of firms:An entrepreneur who has enough capital and still can start the business and enter the industry and any one who is incurring loss can stop the production and exit the industry. 4. Firms are price takers:As there are many buyers and sellers nobody can influence the price or the supply in the industry. They are like drop in the ocean. Producers are price takers as he cannot affect the market price. Consumers are price taking consumer as they cannot influence the price by any of his or her action. 5. Perfect Knowledge: All the buyers and sellers have perfect knowledge about the market. A market which comes to exhibit all these conditions is the stock market. About one stock there are many information available as it is published. 6. No Cost of Transportation:It is assumed cost of transportation does not exist. 7. Perfect mobility of factors of production:It is assumed that all the factors of production can be migrated from one place to another. There is no hindrance in the movement. This helps in entry of new firm and exit of a loss making firm.
  2. 2. Now after discussing the features we will differentiate between perfect and pure competition. As perfect competition has all the features of pure competition and some more features. The first three features given under perfect competition constitutes pure competition (that is large number of sellers and buyers, free entry and exit and identical products) where as perfect competition has the features of pure competition and two more features they are perfect knowledge about the market and perfect mobility of inputs and output. Shut Down Point:In short run, firm may continue its production to recover losses in long run. In short run as we have discussed in cost concept fixed cost is incurred even if the output is 0. Now when the firm is incurring loss then it may go on producing till the loss is less then or equal to total fixed cost. then the firm may go on producing till the loss less is then and equal to TFC. If the firm is able to cover its variable cost and part of fixed cost it will go on producing because if it stops, the firm has to incur the complete fixed cost as loss and as there will be no variable cost if there is no production but if the loss is more than fixed cost that is when producers will decide to shut down. Therefore not only the whole of fixed cost but also the part of variable cost the firm has to incur from its pocket, not through revenue. It is advisable to shut down and incur loss equal to fixed cost as there will be no variable cost when production is nil. Long Run Equilibrium:We assume that all the firms have identical cost condition in the industry. In short run the firm will keep on producing even when it is incurring loss but in long run the firm not even getting normal profits will shut down. As due feature of free entry and exit when a firm at shut down point will exit the industry which will decrease the supply and the profit increase and other firms who where are incurring loss will start getting normal profit. When most of the firms are incurring profits the industry looks attractive many new firms enter the industry which increase the supply in the industry and the profit comes down and the existing firms will return to normal profits from super norm at profits so in long run under perfect competition the firm incurs normal profit there are no super normal profit and no huge loss.
  3. 3. MONOPOLY Monopoly is said to exist when one firm is the sole producer or seller of the product. In case of monopoly, one firm constitutes the whole industry. Mono means one and Poly means seller. Conditions 1. One seller or producer. 2. No close substitutes for the product of that firm should be available. 3. monopoly implies no competition 4. Other firms for one reason or the other reason are prohibited to enter the industry. There is strong barrier to the entry of the firms. Price discrimination Practice of selling the same commodity, at different price to different buyers by a seller. A seller makes price discrimination between different buyers, when it is both possible and profitable for him to do so. Its difficult to charge different price for the identical good from different buyer. Three degrees of price discrimination 1. First degree price discrimination – first degree price discrimination is also called the perfect price discrimination because this involves maximum possible exploitation of each buyer in the interest of the seller’s profit. It is said to occur when the seller is able to sell each separate unit of the product at different price. So every buyer is forced to pay the price which is equal to maximum amount he is willing to pay rather than to go without the good altogether, which means seller leaves no consumer surplus to the to buyer. Seller makes separate bargain with each seller instead of setting down with just two or three few market prices each. In this all and nothing bargain the total amount of money which the buyer is required to give equal to the maximum price he is wiling to pay. 2. Second degree price discrimination - second degree price discrimination will occur if the monopolist is able to charge separate price in such a way that buyers are divided into
  4. 4. 3. different groups and each group is charged a different price. The seller divides his market into different group of buyer and charges different price for each group of buyer. Third degree price discrimination- when the seller divides his buyer into two or more than two sub markets or group and charges a different price in each submarket. The price charged in each sub market depends upon the output sold in that submarket and demand condition of that submarket. It is the most common, e.g. price discrimination found in the practice of manufacturers who sells his product at a higher price at home and lower price abroad. Monopsony Monopsony refers to a market situation when there is a single buyer of a commodity or services. It applies to any situation in which there is a monopoly element in buying. E.g. when a single factory in an isolated locality is the sole buyer of some grades of labour or when a individual happens to have a taste for some commodity which no one else requires. Just as in monopoly seller is able to influence the price of the product by the amount he offers for sales. Similarly monopsony buyer is able to influence the supply price of his purchase by the amount he buys. Monopoly aim to maximum profit and monopsony aims to maximum consumer surplus. Bilateral monopoly Bilateral monopoly refers to market situation in which a single producer (monopoly) of a product faces a single buyer (monopsony) of that product. There is a single commodity with no close substitutes, the monopolist is the sole producer and the monopsonist is the only buyer. Both are firm to maximize their individual profits. The actual quantity sold and its price depends upon the relative bargaining strength of the two. The price tends to settle down between the monopoly price and monopsonist price. Monopolistic competition
  5. 5. Monopolistic competition is a form of market structure in which a large number of independent firms are supplying product that are slightly differentiated from point of view of buyer. This situation arises when the same commodity is being sold under brand names e.g. lux, rexona, dove etc. each firm is sole producer of particular brand. They are monopolist as far as that particular brand is concerned. Since various brands are close substitutes, there is keen competition with each other. Product differentiation It does not mean that the product of various firms are altogether different, they are slightly different which means they are close substitutes. They are not identical as in perfect competition but neither are they remote substitutes as in monopoly. The products are fairly similar and serves as close substitutes for each other Two bases of product differentiation 1. Characteristic of the product- such as features, trademark, trade names etc. real quantitative difference like those of material used, design and workmanship are no doubt important means of differentiating products. But imaginary difference created through advertising, the use of attractive package, brand name are more usual methods by which products are differentiated even if physically they are identical or almost so. 2. Condition surrounding the sales of the product- the service rendered in the process of selling the product by one seller is not identical to that of the other. E.g. seller’s reputation of fair dealing, efficiency, general terms, his way of doing business, seller’s location etc. Selling cost and advertisement Under monopolistic competition, the firm often competes through selling cost and advertisement expenditure. To increase the demand for their product and thereby increase the revenue made. The selling cost is broader than advertisement expenditure, where as advertisement expenditure includes cost incurred only on getting the product advertised in newspaper, magazines, radio, television but selling cost includes the salaries and wages of salesmen, allowance to retailers for the purpose of getting their products displayed and so many types of promotional activities besides advertisement.
  6. 6. Production cost is the cost of production includes all those expenses which are incurred to manufacture and provide a product to meet the given demand or want, while the selling cost are those which are incurred to change, alter or create the demand for the product. It should however be noted that the distinction between production costs and selling costs cannot always be sharply made e.g. it is difficult to say whether the extra cost of attractive packaging is production cost or selling cost, since purpose of advertisement is to increase or create the demand for the product. Importance of selling cost Under monopolistic competition with product differentiation the advertisement and other selling cost becomes important as a competitive weapon at the disposal of the firm to increase the sales at the expense of the other. This is because the products are close substitutes; each firm tries to convince the buyer that its product is better than the other in the industry. A firm under monopolistic competition may keep its price and product design constant and seek increase in demand if its product by increasing the amount of advertisement expenditure and through it persuading the buyers that his brand is superior to the others. Oligopoly In oligopoly the competition between the few Characteristics 1. Interdependence- the most important feature of oligopoly is the interdependence in decision making between the few firms which comprises the industry. When the numbers of competitors are few, any change in price, output etc by a firm will have direct effect on the rivals which will then retaliate in changing their own prices. 2. Importance of selling cost and advertisement - a direct effect of interdependence of oligopolies is that the various firms have to employ various aggressive marketing weapons to gain a greater share in the market or to prevent a fall in the share for which the firms have to incur a great deal of cost on
  7. 7. 3. advertisement and other measures of sales promotion. Thus, there is great importance for selling cost and advertisement Group behaviour- perfect competition, monopoly and monopolistic pose no problem of making suitable assumption about human behaviour. Assumption of profit maximization gives overall good results in these situations where mass of people are involved and there is no interdependence of the firms. But in oligopoly the theory of group behaviours is important as there is interdependence between the members of the group. Do they form a group and agree to pull together in promotion of common interest or will they fight to promote their individual interest. Indeterminateness of demand curve The demand curve shows what amount of the product a firm will be able to sell at various prices. In case of other market situation we can have definite demand curve but under oligopoly the interdependence of the firm. Under oligopoly the firm cannot assume the rivals will keep their price unchanged, so the demand curve faced by oligopolistic firm loses its definiteness. Since, it goes on constantly shifting as the rivals change the prices in reaction to price changes by firm. Is price and output under oligopoly indeterminate? The interdependence of firms and uncertainty about the reaction patterns of individual reaction patterns of individual rivals, the easy and determinate solution to the oligopoly problem is not possible 1. 2. In the market situation wide variety of behaviour pattern are possible, rivals may decide to get together and co-operate or at the other extreme, they may try to fight each other to death. Another difficulty is indetermination of demand curve facing individual firms, because of the interdependence of oligopolistic firm cannot assume that its rivals firm will keep their price and quantity constant, when it makes change in its price. Therefore an oligopolistic firm cannot have sure and definite demand
  8. 8. curve, since it keeps shifting as the rivals change their prices in reaction to the price changes made by it. The determinate solution to the oligopoly problem has been provided in the following ways – 1. oligopolistic firm ignores interdependence. Now when interdependence disappears from decision making of the firms, the demand curve facing them becomes determinate and can be ascertained 2. second approach to provide determinate solution to the price and output problem of oligopoly is to assume that the oligopoly firm is able to predict the reaction pattern and counter moves of the rivals 3. Third approach assumes that the oligopolistic firms realizing their interdependence will purse their common interest and will form collusion and enter into agreement and work in common interest. They will maximize the joint profit and share the profit, market or output as agreed between them. 4. Another approach is the game theory – in the theory of game, an firm does not guess at its rivals reaction pattern but calculates the optimal moves by rival firms that is their best possible strategies and in view of that adopt its policies and counter moves. Collusive oligopoly Setting price independently is rare in oligopoly markets. This understanding or agreement among the oligopolist may be either formal or informal. A formal agreement is one when the oligopolist after consultation and discussion agree to observe certain common rules of conduct in regard to price. They may make a written agreement which may also provide for penalties to those who violate the agreement reached. Tacit or informal agreement is without face to face contact, consultation or discussion they come to have some understanding between them and pursue a uniform policy with regard to price output etc. in order to avoid price war and cut throat competition, they enter agreement regarding a uniform price-output policy to be pursued by them.
  9. 9. Collusive oligopoly is of two types 1. 2. cartels price leadership Cartels in cartel type of collusive oligopoly price is jointly fixed and output policy through agreement. Joint profit maximization Let us assume that two firms have formed a cartel by entering into agreement, we also assume that the cartel will aim at maximizing joint profit for the member firms. As the demand curve facing a cartel will be aggregate demand curve facing consumers of the product, it will be downwards sloping. Joint profits are maximized by fixing the industry output at the level at which marginal revenue curve intersects the marginal cost. having decided the output to be produced, the cartel will a lot output quota to be produced by each firm as that the marginal cost for each firm is the same, the profit made by individual firms will not be retained by them but instead they will be brought under a common pool. These profits will be divided by the member firms according to the terms of agreement reached between them at the time of forming the cartel. The allocation of output quotas of each of them is made on the grounds of minimizing costs and not as a basis for determining profit distribution. Market sharing cartels Under market sharing by non-price competition only on uniform price is set and member firms are free to produce and sell the amount of output which will maximize the individual profits. Though the firms agree not to sell at a price below the fixed price, they are free to vary the style of their product and advertisement expenditure. Of the different member firms have identical costs, then the agreed uniform price will be the monopoly price which will ensure the maximization of joint profits. But if the cost differs, the cartel price will be fixed by bargaining between the firms. The level of the price will be such that it ensures some profits to high cost firms. With cost difference the cartels are quiet unstable. low cost firms will have incentives to cut he price and increase their profits and therefore that will led to break
  10. 10. away from cartel. However they will not openly charge low price but by giving secret price concessions to the buyers, when this is discovered and open war may commences and the cartel breaks. Market sharing by quotas This type of market sharing cartel is the agreement reached between the firms regarding quota of output to be produced and sold by each of them agreed price. When costs of member firms are different, the different quota for various firms will be fixed and therefore their market share will differ. The quotas and market shares in case of cost difference are decided by bargaining between the firms. The quotas and market sharing is the division of market region-wise that is geographical division of the market between the cartel firms. Price leadership Price leadership is the important form of collusive oligopoly 1. Price leadership by low cost firm – in order to maximize profit the low cost firm sets a lower price then the profit maximizing price if the high cost firms. Since the high cost firms will be unable to sell their product at the higher price, they are forced to agree to the low price set by the low cost firms. The low cost leader will ensure that price he sets must yield profits to high cost firms 2. Dominant firm price leadership – this dominant firm yields a great influence over the market of the product while other firms are small and are not capable of making any impact on the market. As a result a dominant firm estimates its own demand curve and fixes prices which maximize its own profit. The other firms which are small having no individual influence on the price follow the dominant firm and accept the price set by him, adjust their output accordingly. 3. Barometric price leadership- under which in old, experienced, largest and the most respected firm assumes the role of custodian who protects the interest of all. He assesses the change in the market condition with regard to the demand for the product, cost of production, competition from the related
  11. 11. product etc and makes changes in the price which are best from the view point of all firms in the industry. 4. Exploitation or aggressive price leadership – under which a very large and dominant firm establishes its leadership by following aggressive price policies and thus compels the other firms in the industry to follow him in respect of price. Such a firm will often initiate a move threaten to compete the other out of the market, if they don not follow him in setting their price. Kinked demand curve In oligopoly price remains sticky that is there is no tendency on the part of the firm to change price of the commodity even if the economic condition under go changes. The demand curve facing an oligopolist has a kink at the level of prevailing price. The kink is formed at the prevailing price level because the segment of demand curve above the prevailing price is highly elastic and the segment of the demand curve below the prevailing price is less elastic. A kinked demand curve dD with a kink at point P has be shown. The prevailing price level is OP and the firm is producing and selling the output OM. Now, the upper segment dk of the demand curve dD is relatively elastic and the lower segment KD is relatively inelastic. Each oligopolist believes that if he lowers the price below the prevailing price, his competitor will follow him and will accordingly lower their prices, where as if he raises the price
  12. 12. above the prevailing price level, his competitors will not follow his increase in price. Rivals will not match his increase in price above the prevailing level; they will indeed match its price cuts. 1. Price reduction – if the oligopolist reduce its price below the prevailing price level on order to increase his sales, the competitor will fear the customers will go to other firms who has reduced the price, so to retain the customers he has match the rice cut. The competitor will quickly follow the reduction in price by the oligopolist, he will gain in sales only very little, which means the demand is inelastic below the prevailing price. Demand from D to k which lies below the prevailing price is inelastic as very little increase in sales can be obtained by a reduction in price by an oligopolist. 2. Price increase – if an oligopolist raises his price above the prevailing level, there will be substantial reduction in his sales. This is because as a result rise in price many of his customers will withdraw from him and will go to his competitor who will welcome them and will gain in sales. These happy competitors will have no motive to match the rise in price, so small increase in price is followed by large reduction in sales above the prevailing price that is why the demand curve dk tend to be highly elastic. Price does not always remain sticky The kinky oligopoly demand curve theory, dose not follow that the price always remains the same. Whenever the costs and demand conditions undergo changes and when it is likely to remain inflexible in the face of changing costs and demand conditions is explained below 1. Decline in costs- when the cost of production declines, the price is more likely to remain stable. When the cost of production falls, then the segment of demand curve above the prevailing current price will become more elastic because with lower costs there is a greater certainty that in increase in price by oligopolist will not be followed by the rivals and thus will cause greater loss in sales. On the other hand the lower segment of the demand becomes more inelastic as there is
  13. 13. great certainty that reduction is price will be followed by the rivals. 2. Rise in price – if there is a rise in the cost, the price is not likely to stay rigid. When there is rise in the cost of the industry an oligopolist can reasonably expect that his increase in price will be followed by the other in the industry. As a result, the segment of the demand curve above the prevailing price will become less elastic. 3. Decrease in demand – prices are likely to remain inflexible and not fall when the demand decreases, it becomes more certain that if one oligopolist decreases the price, others will follow with the reduction, as a result the lower segment of the demand curve which below the prevailing price becomes more inelastic. 4. Increase in demand – when the demand increases, the price is unlikely to remain stable instead price is likely to rise. An oligopolist can expect that if initiates the increases in price, his competitor will most probably follow him. Therefore, the upper segment of the demand curve will become less elastic.