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Market structure now

  1. 1. Market structure Goal of the firm 1. Profit maximization This occurs at the level of output where profits cannot be increased any further ie MR>MC. Profit maximization occurs where MR=MC. 2. Growth – Businesses want to increase their size 3. Sales and Revenue Maximization – firms are prepared to accept a lower price and produce above the profit maximization output in order to increase its market share. 4. Market Dominance – The pursuit of sales or revenue maximization 5. Satisficing – Making reasonable profits that is sufficient to satisfy the shareholders as well as to keep the work force and consumers happy. Revenue Total Revenue – the firm’s total earnings per period from the sale of particular amounts of output. TR = P x Q Average Revenue – earnings per unit TR/Q Marginal Revenue – The additional revenue from the sale of an additional product. ∆TR/∆Q Profit This occurs when revenue is greater than cost. It is the minimum return the owner must make in order to remain in business. There are two types of profit namely normal and abnormal (pure/economic/supernormal/excess) profits. Normal Profits (MR =MC) 1
  2. 2. • The opportunity cost of being in business ie the profit that could have been made in the next best alternative business. It is the profit necessary to persuade firms to stay in business in the long run but not enough to attract new firms to the industry. If normal profits are not being made in the long run it would be best to shut down the business. Abnormal Profit TR>TC or MR>MC. This is where profits are greater than normal. In the long run new firms are attracted to the industry. 2
  3. 3. Loss TC>TR or MC>MR Less than normal profits. Firms want to leave the industry. Market Structure The characteristics of a market that influence the behaviour and performance of firms that sell in the market 3
  4. 4. Major types 1. Perfect competition 2. Monopoly 3. Monopolistic competition 4. Oligopoly Perfect Competition A market that consists of a large number of firms producing an homogeneous product. This market structure does not really exist. Assumptions/ features/characteristics 1. There are many suppliers who do not own a significant share of the market. Therefore firms do not have control over price and are considered price takers. 2. Products are identical. Therefore they are perfect substitutes for each other. 3. Consumers have perfect information about prices. Therefore firms cannot charge a higher price as consumers can easily find cheaper substitutes for the ruling price. 4. All firms have equal access to resources 5. No barriers to entry and exit in the long run. This cause firms to only make normal profits in the long run. Profit Maximization Firms can sell any amount at the existing market price as they are price takers. Revenue is the market price and quantity produced. TR = PxQ. For instance if the price of Pepsi Bubbla is $50 and 20 Bubblas are produced then TR is $50 x 20 = $1000. Note that MC varies with output firms will continue producing in the short run as long as MC is equal 4
  5. 5. to market price and in the long run as long as market price is greater than the AVC. Profit is maximized where MR=MC=P. The market sets the price so in order to increase sale the produce has to supply and sell large amounts. A firm operating under Perfect Competition will always produce at the level of output where the MC of the last unit produced is just equal to the market price. Short-run The industry sets the price through the forces of demand and supply. The firms will then have to sell at this price. Any amount of output can be sold at this price (perfect elasticity). If one firm were to increase the price consumers would not buy their products and if the firm were to sell at a lower price it would loose. Therefore it would be best to sell at the market price. Abnormal profits can be made in the short run. Abnormal Profits Price is constant therefore AR=MR. Profit maximization occurs where MR=MC. The profit maximization quantity is Q1. Price in greater than average cost therefore abnormal 5
  6. 6. profits are made. However if the market price is lower than the AC then losses would occur in the short run. Losses Firms may also make normal profits in the short run. Long run curves 6
  7. 7. In the long run abnormal profits will attract new firms to the industry because there are no barriers and firms have perfect knowledge of what is happening in the market causing supply to increase forcing down the market price, demand increases to AR2 = MR2. Abnormal profits will be competed away or exhausted and only normal profits (zero economic profits) are made. Existing firms will remain in the industry; however no new firms will enter the industry. As it relates to losses in the short run, in the long run firms will exit the industry shifting the supply curve to the left. Price will increase until normal profits are made. Graph Long run industry supply curve Constant cost – more is supplied at the same price in the long run. The curve is horizontal. Demand increases and abnormal profits are made. New firms enter the industry shifting the supply curve to the right until the price returns to its old level. Graph 7
  8. 8. Decreasing cost As firms expand/buy new technology they experience economies of scale. Price falls. In the long run the supply curve slopes downwards, more is supplied at a lower price in the long run Graph Increasing cost As new firms enter the industry price/cost of raw materials increase, more is supplied at a higher price in the long run. The long run supply curve slopes upwards. Graphs Shut down 8
  9. 9. Short run – price must cover AVC. Supply is MC above AVC. If this is not happening shut down. Long run – Firms must cover AC or ATC. Supply is MC above ATC or AC. If this is not happening shut down. Benefits of Perfect Competition 1. In the long run firms only make normal profits which is good for the consumer 2. They are allocative efficient as they produce where P=MC 3. They are productive efficient as they produce at the lowest possible cost per unit ie the bottom of the AC 4. More efficient firms make abnormal profits in the short run so it is an incentive for firms to be innovative and efficient. 9
  10. 10. Disadvantages 1. Firms cannot afford research and development to earn economies of scale in the long run because only normal profits are made in the long run 2. Firms lack variety 3. Firms are too small to have any dominance over the market. Total Approach Comparing total revenue with total cost to get the largest possible positive difference ie TR>TC. (see cape book page 101- 102) Marginal Approach Compares the addition profit form the production and sale of an additional product. This is the most widely used method of determining profit maximization. MR>MC firm can produce more, MR<MC profits are falling so reduce production, MR=MC profit is maximized. (see cape book page 102- 103) Monopoly Definition Monopoly is characterized by the absence of competition. It is a situation where single company owns all or nearly all of the market for a given type of good or service. The firms are able to operate without competition by establishing barriers to entry. 10
  11. 11. Reasons for the existence of monopolies/ Barriers to entry 1. Secret formula that no other competitor or potential competitor is able to breach. The firm may patent its unique formula for instance KFC 2. Access to strategic raw materials 3. The size of the market allows for only one firm to subsist. These monopolies are called natural monopolies eg public utility firms in CARICOM 4. An industry may have more than one firm. However the most efficient firm with the largest resource base can charge a lower price for its commodity compared to its rival. Through what is known as limit pricing the most efficient firm can outcompete its rivals and gain control of the market. A more established firm can build their goodwill and establish credit ratings to obtain preferential access to credit from financial institutions. 5. The government may offer permission to franchise for instance KFC is owned by Prestige Holdings in T&T. 6. Economies of scale 7. mergers and takeovers 8. Product loyalty 9. Intimidation and aggressive tactics Sources of monopoly 1. Natural monopolies 2. Capital requirement – expensive to set up (nuclear plant) 3. Technological – reduces cost per unit 4. Legal - government grants patent or copyrights 11
  12. 12. 5. Public- monopoly by law like the post office Assumptions/ Features/Characteristics 1. There is one seller and many buyers therefore monopolies have significant control over price. Hence they are price makers. They can increase prices at anytime unlike those firms operating under perfect competition. 2. The product is unique and does not have close substitutes. JPS, NWC 3. Profit Maximizer: Maximizes profits where MR=MC 4. High Barriers to entry and exit: Other sellers are unable to enter the market of the monopoly to compete away their supernormal profits made in the short run. 5. Price Discrimination: A monopolist can change the price and quality of the product. He sells more quantities charging less for the product in a very elastic market and sells less quantities charging high price in a less elastic market. 6. The demand curve tends to be downward sloping and more inelastic than the oligopoly. The demand curve The firm and industry demand curve is the same. It is downward sloping which means in order to sell more market price must fall. The downward sloping curve means that MR curve at the firm diverges from the AR curves. The MR falls below the AR or demand curve unlike perfect competition where MR=AR=D. AR and MR 12
  13. 13. Total Revenue curves In the elastic portion of the curve MR is positive and so increasing quantity increases TR. But where demand is price inelastic MR is negative and increases in quantity produced reduces TR. Where elasticity is 1 MR is zero TR is at its highest. The monopolist should therefore operate along the elastic portion of the curve. 13
  14. 14. Profit maximization The monopolist's profit maximizing level of output is found by equating its marginal revenue with its marginal cost, which is the same profit maximizing condition that a perfectly competitive firm uses to determine its equilibrium level of output. Indeed, the condition that marginal revenue equal marginal cost is used to determine the profit maximizing level of output of every firm, regardless of the market structure in which the firm is operating. Short run equilibrium of the firm and industry 14
  15. 15. The monopoly like ant other firm maximizes profits where MR=MC so it would be ideal to sell at this price. However, in order to make abnormal profits the firm will sell Qm at Pm which is above the AC curve. These abnormal profits may remain in the long run because of barriers to entry and imperfections in the market. The firm may make normal profits where AR=AC 15
  16. 16. It is also possible for monopolies to make losses where AC is greater than AR The long run position of the monopolist Barriers to entry and imperfect knowledge cause abnormal profits to remain in the long run. Monopoly and deadweight loss 16
  17. 17. This occurs because the monopoly produces less at a higher price unlike the perfect competitor who produces where MC=AR=D. The monopoly is therefore allocative inefficient because P>MC resulting in deadweight loss. Advantages of monopoly  A monopoly enjoys economics of scale as it is the only supplier of product or service in the market. The benefits can be passed on to the consumers.  Due to the fact that monopolies make lot of profits, it can be used for research and development and to maintain their status as a monopoly.  Monopolies may use price discrimination which benefits the economically weaker sections of the society. For example, Indian railways provide discounts to students travelling through its network.  Monopolies can afford to invest in latest technology and machinery in order to be efficient and to avoid competition.  Monopoly avoids duplication and hence wastage of resources. Disadvantages  They are allocative inefficient as P>MC which cause market failure  They are productive inefficient as they do not produce at the bottom of the ATC curve.  Compared to s perfectly competitive industry with the same cost and demand conditions, the monopolist will charge a higher price for less output.  Poor level of service, inefficiency and complacency  No consumer sovereignty. 17
  18. 18.  Consumers may be charged high prices for low quality of goods and services.  Lack of competition may lead to low quality and out dated goods and services. Natural Monopoly An industry in which the firm produces enough to meet the entire demand at a lower cost than two or more other firms. Left unregulated it produces where P=AR; regulated it produces where P=MC. The size of the market allows for only one firm to subsist eg public utility firms in CARICOM. An industry in which economies of scale makes it possible for a firm to dominate the entire market as a result of a AC. This type of monopoly is especially likely to occur if the market is small. The firm does not have to be large but its size relative to the total market demand for the product does matter. Supernormal profits are made when only one firm is in the industry but when another firm enters the industry they may have to share the market the demand curve may pivot inwards and both firms may end up losing. Graph 18
  19. 19. New Entrants and the existing monopoly Graph The existing firm set their prices below the average cost of the new entrant making it difficult for the firm to survive in the industry. Price Discrimination Where the same commodity is sold to different consumers in different markets for different prices for reasons that have nothing to do with cost, for this to occur: 1. Markets must be separable , with different price elasticities of demand 2. Arbitrage (taking advantage of a price difference between two or more markets) must not be possible. First-degree price discrimination The seller can charge each consumer the maximum amount they are willing to pay for each unit of the product purchased. The producer gets the entire consumer surplus. For instance doctor charges his patient based on the patient’s perceived willingness and ability to pay. This is perfect discrimination because the firm has perfect knowledge about their consumers and uses this knowledge to receive the highest payment possible. Graph 19
  20. 20. Second-degree Price discrimination This is called quantity discrimination. The firm does not have perfect knowledge of the consumer. This is where the consumer is charged different prices based on the quantity of the commodity purchased. The consumer will pay more for the first unit of the commodity and less for successive units of the commodity, so they may want to pay $60 for the on unit of water but $40 for each unit of water when buying a case of water. You tend to pay relatively less for a larger soda than a smaller one. Graph 20
  21. 21. Third-degree price discrimination This is the most common type where distinct prices are charged in each of the different markets. The monopolist can only discriminate if the elasticity of demand can be identified and exploited. The monopolist can charge the highest price in the market for which demand tends to be inelastic than in the market where demand is elastic. Graph Market a Market b The firm 21
  22. 22. Quantity supplied for each market is where MC= MRa = MRb. However in market ‘a’ the firm can charge as much as P to earn a greater revenue than in market ‘b’ where it can charge as much as P2. Monopolistic Competition This is a market structure in which large number of firms produces differentiated products but compete for the same consumers. Examples: • The restaurant business • Hotels and bars • General specialist retailing • Consumer services, such as hairdressing Assumptions/ Features/Characteristics 1. Large number of buyers and sellers. Each firm controls a small portion of the market. Each firm act independently of each other in terms of pricing and output policies. 2. Weak barriers to entry and exit 3. Perfect knowledge of the market 4. products are differentiated 5. Firms are price makers 6. Firms advertise 7. The demand curve is downward sloping and fairly elastic Nature of the product Product differentiation means that products have attributes which make them different for instance in terms of material used to produce the good, colour, taste etc. There 22
  23. 23. may be a perceived difference as a result of advertising. The aim of differentiation is for the consumer to think that the product is unique. Product differentiation implies that the products are different enough that the producing firms exercise a “minimonopoly” over their product this depends on the company’s success at differentiation. The firms compete more on product differentiation than on price. Entering firms produce close substitutes, not an identical or standardized product. The firm has multiple dimensions  One dimension of competition is product differentiation.  Another is competing on perceived quality.  Competitive advertising is another.  Others include service and distribution outlets. Profit Maximization Profit is maximized where MR=MC Like a monopoly • The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve • Marginal revenue is below price • At profit maximizing output, marginal cost will be less than price Like a perfect competitor, zero economic profits exist in the long run  A monopolistically competitive firm prices in the same manner as a monopolist— where MC = MR.  But the monopolistic competitor is not only a monopolist but act like a perfect competitor as well. 23
  24. 24. In the short run the firm can make abnormal profits though product development and advertising. However if the addition cost of advertising is greater than the additional revenue from advertising then losses will occur. Normal profits can also be made in the short run. Profit is maximized where MR=MC. Supernormal profit are made in the short run. The size of this profit depends on the strength of demand, the elasticity of demand, and the uniqueness of the product. 24
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  26. 26. 1. At equilibrium, ATC equals price and economic profits are zero. 2. This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm. In the long run new firms enter the industry and abnormal profits are competed away. Non-Price Competition The firm attempts to establish its product as a different product from that offered by its rivals. 26
  27. 27.  Differentiation means that in the consumer’s mind, the product is not the same. Marketing is often the key to successful differentiation. Firms may differentiate products by perceived quality, reliability, colour, style, safety features, packaging, purchase terms, warranties and guarantees, location, availability (hours of operation) or any other features.  Brand names may signal information regarding the product, reducing consumer risk. A brand name is valuable to a firm; it makes the demand less elastic and can enable the firm to earn higher profits. Once a consumer has had a positive experience with a good, the price elasticity of demand for that good typically decreases—the consumer becomes loyal to the product. Monopolistic competitive firms are allocatively inefficient because P>MC and productively inefficient since they are not producing at their lowest cost per unit ie the minimum AVC. 27
  28. 28. Advantages of Monopolistic Competition 1. The Promotion of Competition (lack of Barriers to Entry) 2. Differentiation Brings Greater Consumer Choice and Variety 3. Product and Service Quality – Development – greater incentive to increase this to earn supernormal profits 4. Consumers become more knowledgeable of products through marketing and Advertising Disadvantages 1. They can be wasteful -- Liable of Excess Capacity - Some firms don't produce enough output to efficiently lower the average cost and benefit from economies of scale and reduces their economic profits. The cost of packaging, marketing and advertising can be considered extremely wasteful on some levels. 2. Allocatively Inefficient 3. Higher Prices 4. Advertising - It distorts what consumers’ desire, as well as reduces competition as consumers become captivated over the perception of differentiation. Limitations of Monopolistic Competition 1. Firms do not have perfect knowledge of the market 2. It is impossible to derive an industry demand curve because products are differentiated 3. The firm may take part in non-price competition in order to maximize profits 4. Entry is not completely unrestricted because some firms have cost advantages or their products are difficult to duplicate. 28
  29. 29. 5. It may be difficult to forecast the effects that product development and advertising will have on demand 6. Advertisements may have different effects at different price levels and different profit maximization points Oligopoly Oligopoly refers to a market with "few sellers". Oligopolies interact among themselves. When an oligopolist changes a price, it must take into account how other firms in the industry will respond. Within an oligopoly, the products can be similar or differentiated. Oligopoly markets have high barriers to entry. Examples of Oligopoly  Automobile industry  Airline industry  Cigarettes  Cleaning products  Electrical appliance Characteristics of Oligopoly 1. Industry dominated by small number of large firms - Supply is concentrated in the hands of a relatively few firms. 2. Many firms may make up the industry 3. High barriers to entry - Substantial barriers, similar to monopoly but not as restrictive may be present. Oligopolies are large firms and benefit from economies of scale. It takes considerable “know-how” and capital to compete in this industry. 29
  30. 30. e.g. Petroleum or oil industry. In the long run dominant firms can maintain supernormal profits. 4. Products could be highly differentiated – branding or homogenous Homogeneous product- pure oligopoly. e.g. Raw materials (oil, petrol, tin). Differentiated product- imperfect/ differentiated oligopoly. e.g. (Cars, detergent) 5. Non–price competition - Compete not through price but other methods (advertising, after-sales service, free gifts). Practiced by oligopoly and monopolistic competition. Various forms: a. Competitive advertising – to reinforce product differentiation and harden brand loyalty. b. Promotional offers – e.g.. Household detergent, toothpaste, shampoo (buy 2 get 1 free), (25% extra at no extra cost). c. Extended guarantees/after sales service – esp. for consumer durables, by offering free spare parts, labour guarantee. d. Better credit facility e. Attractive gift wrappings 6. Price stability within the market - kinked demand curve? - Prices are very inflexible. Despite changes in underlying costs of production, firms are often observed to maintain prices at a constant level. The kinked demand curve theory is used to show price rigidity in an oligopoly market structure. 7. Potential for collusion? - Make agreement amongst them so as to restrict competition and maximize their own benefit. 30
  31. 31. 8. High` degree of interdependence between firms - Oligopoly firms are large relative to the market in which they operate. If one oligopoly firm changes its price or its market strategy, it will significantly impact the rival firms. E.g. if Pepsi lowers its price to 60 dollars a bottle, coco cola will be affected. If coco cola does not respond, it will loose significant market share. Therefore coco cola will most likely lower its price too. In oligopoly a firm not only considers the market demand for its products but also the reaction of other firms in the industry. Advantages 1. When firms collude – monopoly –supernormal profit – extra profit – extra capital – to fund R&D – benefit to consumer. 2. Product differentiation – non-price competition– greater variety to consumers. 3. Price stability/rigidity – helps in planning, reduce uncertainty. Disadvantages 1. Collusive oligopoly - if they agree upon output – no variety and improvement in quality – bad for consumers. 2. Acting like a monopoly  Restrict output and charge a higher price  Producer sovereignty  Consumer sovereignty not respected  Greater inequality in income (supernormal profits) Profit maximization 31
  32. 32. Non-price competition (Collusion)  Oligopolies have strong incentives to collude or form Cartels ( a formal collusive agreement) because while acting together, they can restrict output and set prices so that abnormal economic profits are earned. The individual oligopolist has an incentive to cheat because the firm's demand curve is more elastic than the overall market demand curve. By secretly (tacitly) lowering prices, the firm can sell to 32
  33. 33. customers who would not buy at the higher price, as well as to customers who normally buy from the other firms. The companies act like a single firm. The cartel as a whole will sell at P0 with a perunit cost of A0 resulting in the cartel earning supernormal profits. Oligopolistic agreements tend to be unstable due to these conflicting tendencies. Obstacles to collusion 1. Low entry barriers Particularly as time goes on, more firms will be attracted to the potential economic profits, which will not be sustainable. For example, the OPEC's raising of oil prices during the 1970s and early 1980s enticed more non-OPEC producers to produce more. The market share of OPEC producers was drastically reduced and they had to reduce prices in order to gain market share. In the long run, cartels are not usually successful at raising prices. 33
  34. 34. 2. Antitrust laws These laws prohibit collusion. Although firms may make secret agreements, those agreements will not be enforceable in a court of law. 3. Unstable demand conditions These laws prohibit collusion. Although firms may make secret agreements, those agreements will not be enforceable in a court of law. 4. Increasing the number of firms An increasing number of firms in an oligopolistic industry will make agreements harder to discuss, negotiate and enforce. Differences of opinion are more likely. As the number of firms in the industry increases, the industry will behave more like a competitive market. 5. Difficulties with detecting and stopping price cuts These difficulties will undermine effective collusion. Sometimes oligopolistic firms will cheat by enacting quality improvements, easier credit terms and free shipping. If quality changes can be used to compete, collusive price agreements will not be effective. Non-collusive Behaviour (the Kinked Curve) This model recognizes that demand for a firm’s product is determined both by the market demand for a product as well as by rival firm’s behavior. Firms compete for consumers. The demand curve has two distinct parts that are relatively elastic and relatively inelastic. The firm sells Q0 at P0. If the firm were to increase price above P0, other firms will not respond cause the firm to loose a substantial amount of its market share. But if the firm were to decrease it price below P0 then other firms would do the same in order for them 34
  35. 35. not to loose their market share. This would lead to small increases in output along the inelastic segment of the demand curve. The Kinked Curve The non-collusive firm and MC and MR The MR will have a kink at Q0 which corresponds to the point where the demand curve is kinked. The profit maximization point is Q0 where the MC cuts the MR anywhere within the break or gap. Although the cost level changes that is MC1 moves from MC0 to MC the market price of the commodity remains the same. Therefore oligopolists are characterized by price stickiness and therefore are more likely to engage in non-price competition rather than compete on the basis of price. 35
  36. 36. Game Theory applied to oligopoly Firms consider their rival when making policy decisions. Game theory is useful in explaining individual Concentration ratio – the proportion of market share accounted for by top X number of firms: ◦ E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share ◦ 3 firm CR of 72% - top 3 firms account for 72% of market share e.g. The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this ‘independents’ group.  An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers. 36
  37. 37. Characteristics Perfect Monopoly Monopolistic Oligopoly Barriers to entry and competition Freedom of Strong barriers competition None Some exit Control over the entry and exit The industry Significant No firm has Control over market and price sets the price. market power strong control prices and The firm is a and set prices over the firms engage price taker. P=AR market price in price Firms have no because there fixing. P=AR control over are a large prices. P=MC number of P=MR firms. In the short run P= AR>MC in the long run P>ATC Homogenous/ but similar to Unique identical Homogenous or the Nature of the goods P=AR Differentiated differentiated competitor’s Competitive No sales Practice price product Price is at AR behaviour and promotion discrimination above MC. Does some advertising 37
  38. 38. performance/conduct etc. has to but no Competition and sales increase advertising is based on promotion output and and sales advertising, reduce cost to promotion etc. branding, make profits. packaging and sales Number of buyers Many buyers One seller and promotion. Large number Few large and sellers and sellers many buyers of buyer and sellers and imperfect sellers Imperfect but many buyers imperfect Information Perfect knowledge more perfect than a Profitability Short-run – Earn monopoly Earn abnormal supernormal supernormal supernormal profits or profit in both profits only in profit in the losses are the short run the short run short run and made but in and the long as in the long long run the long run run run new firms only normal enter the profits are industry and made. Firms make compete away these profits to normal i.e 38
  39. 39. Output is Output is determined determined determined determined where where where where MR=MC MR=MC. MR=MC in MR=MC in Pareto the short run. the short run. efficient They have They have Productive excess excess efficient as it capacity in the capacity in produce at the long run as the long run bottom of the output is as output is ATC. below the below the Allocative minimum minimum efficient as it level. level. sells where Productive Productive P=MC and allocative and allocative inefficient. Efficiency/output MR=MC Output is inefficient. Output is Natural Monopoly An industry in which the firm produces enough to meet the entire demand at a lower cost than two or more other firms. Left unregulated it produces where P=AR; regulated it produces where P=MC 3 approaches to determine pricing 39
  40. 40. 1. Do nothing - the firm produces the monopoly output and charges the monopoly price causing inefficiency 2. P=MC – efficiency as a larger output is available at a lower price. However the firm cannot cover its cost of production and will have to be subsidized. 3. P=AC the firm breaks even but efficiency is not achieved. Concentration Ratio and Herfindahl Hirschman Index (HHI) Concentration Ratio is usually used to show the extent of market control of the largest firms in the industry. It is the combined production of the leading 4 or 8 firms in the industry. Or The percentage of sales of the 4 or 8 largest firms in the industry. Formula: Sum of the market share of the leading firms/Total market share X 100% Procedure for calculating concentration ratio 1. 2. 3. 4. Total the amount of production/sales for the entire market Find the share of the market each firm has Add up the market share of the 4 or 8 firms Interpret Interpretation – 0 -40% low concentration (perfect competition) 40 – 60% medium/moderate concentration (monopolistic competition) 60 -100% high concentration (oligopoly, monopoly) Herfindahl Hirschman Index (HHI) The square of the percentage market share of each firm summed over all the firms Steps – 1. Square the market share of each firm 2. Sum the squared market share of the firms Interpretation – 0 -1000 or 0.01 low concentration (perfect competition) 1000 ( 0.01) – 1800 (0.18) medium/moderate concentration (monopolistic competition) 1800 (0.18) or more high concentration (oligopoly, monopoly) 40
  41. 41. Contestable markets In the traditional model of oligopoly it is assumed that there are barriers to entry; in reality it is likely that other firms can enter the market ie it is possible for competition to increase within them and this puts pressure on existing firms to behave efficiently. Firms may act in a competitive manner even when producers are few if the market is easy to enter. High profits will attract new firms to the industry therefore existing firms must be competitive. Assumptions 1. freedom of entry and exit 2. The number of firms competing will vary eg. It may be a monopoly at one time and then there may be many other firms competing at other times 3. firms compete For contestable markets, abnormal profits are earned in the short run which attracts other firms to the market and in the long run only normal profits are earned. A perfectly contestable market is one in which the costs of entry and exit is zero. Firms must be competitive; abnormal profit will attract more firms to the industry leading to lower prices, better quality service, more choice and higher output. Eg banking, in particular internet banking. Sunk cost deters entry into the market and make it less contestable. Hit and run - when firms enter a market and target a particular niche (segment) rather than compete throughout the market. 41
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