Nelson Mandela University BED 1101 - Chapter 9 Market Structures PDF

MARKET STRUCTURES BED 1101  Chapter Outline ▪ After studying this chapter, you should be able to: distinguish between the short-run and long-run profit-maximising position of a monopolistically competitive firm; identify the profit-maximising price, the o...

MARKET STRUCTURES BED 1101  Chapter Outline ▪ After studying this chapter, you should be able to: distinguish between the short-run and long-run profit-maximising position of a monopolistically competitive firm; identify the profit-maximising price, the output and the profit/loss of a firm that is operating in a perfectly competitive market, a monopolistically competitive market or a monopoly market; graphically illustrate and explain how a perfectly competitive firm, monopolistically competitive firm and a monopoly set prices and output in order to maximise profit; describe the characteristics of perfect competition; determine price in a perfectly competitive market for the long term as well as the short term; distinguish the characteristics of monopolies, monopsonies, oligopolies and monopolistic competition; and discuss pricing in various imperfect markets.  Market structures ▪ You have already been introduced to the concepts of supply and demand and should be aware of the fact that a market is in equilibrium where the supply and demand curves intersect. There are, however, a number of different market structures that exist, and an understanding of these structures is integral to understanding how markets function. The types of market structures include the following (Richards, 2019): Perfectly competitive markets Monopolies Monopsonies Oligopolies Monopolistic competition ▪ Each market structure is discussed in more detail below.  Perfectly competitive market ▪ Perfectly competitive markets do not realistically exist; however, the theory behind perfectly competitive markets forms the foundation for the understanding of other market structures. Perfectly competitive markets exist under the following conditions (Lumen Learning [a], n.d.) Characteristics of Perfect Market 1. The market must contain a large number of both buyers and sellers – the number must be so large that no individual buyer or seller will be able to influence the market price. ▪ Thus each firm only supplies a tiny fraction of the total market supply. This will mean that the price of goods is determined by the market forces and not by individual firms. As such, the firms will become price- takers. All the firms have to accept the price determined by the market, and therefore they base their production decisions on the market price.  Perfectly competitive market 2. All the goods produced in the market must be homogenous. This means that all the goods in the market must be identical in all ways, e.g. size, shape and quality. This ensures that no buyer will prefer one firm’s product over another’s. 3. There must be free entry and exit into the market for buyers and sellers. This is a condition under which there are no special costs that make it difficult to enter or exit a market. Therefore, buyers can easily switch from one supplier to another, and suppliers can easily enter or exit the market. This assumption is important for competition to exist. 4. All the market participants must have perfect knowledge of market conditions. This means that buyers and sellers are aware of all the changes in the market. For example, if a firm is charging a price that is higher than the market price, all the buyers will be aware of this, and no one will purchase from that firm.  Perfectly competitive market 6. No government intervention is present in the market. 7. All the factors of production are perfectly mobile. ▪ Although most markets are far from perfectly competitive (as the conditions above are not all met), there are markets which are highly competitive, e.g. agricultural markets.  The demand curve of a perfectly competitive firm ▪ Under perfectly competitive market conditions the individual firm is only a price-taker, as it does not have the power to influence the price of a product. ▪ The market determines the price of the product, and if the individual firm decides to charge a higher price it will lose all of its customers and sell a quantity of zero. ▪ The firm will also not gain anything from decreasing its price, as they can sell any output, they want at the market price. Therefore, a decrease in price will not lead to an increase in the quantity demanded for the firm’s products. ▪ Due to individual firms being price-takers, the demand curve of the firm is a horizontal line. This means that the demand curve is actually equal to the market price – i.e. P1 = D. The demand curve of a perfectly competitive firm  The demand curve of a perfectly competitive firm ▪ A perfectly competitive firm increases its total revenue by selling larger quantities. As already stated, the firm does not have to reduce its price in order to achieve this. ▪ This means that the additional revenue that the firm receives from selling an additional unit of output sold, or marginal revenue (MR), is equal to the market price. ▪ Automatically, this means that the revenue that the firm earns per unit of output sold – i.e., average revenue (AR) – is equal to the market price. Hence, P = MR = AR. The following table illustrates this relationship. Profit maximisation under perfect competition  Perfect competition graphs ▪ Looking at the figure above, the first graph depicts a firm earning an economic profit. ▪ The market price (P1) is equal to the firm’s average revenue, which is equal to their marginal revenue (P1 = AR = MR). ▪ As previously stated, profit is maximised where marginal revenue is equal to marginal cost, which is shown at point E1 on the graph, at a quantity of Q1. C1 represents the average total cost (ATC) to the firm, so the distance from C1 to P1 represents the profit per unit the firm is earning. ▪ The shaded area (C1P1E1M) reflects the economic profit that is earned in the short run.  Perfect competition graphs ▪ Now moving to the next graph, we see a firm earning a normal economic profit. The market price has now fallen to P2, and this leads to a drop in the firm’s average revenue and marginal revenue (P2 = AR = MR). ▪ The profit maximisation point has moved down the marginal cost curve to meet marginal revenue at E2. The quantity demanded has also decreased to Q2. ▪ There is no shaded area which tells us that the firm is now breaking even and is no longer earning the economic profit that it earned in the short run. Normal economic profit is typical for a firm in a perfectly competitive market in the long run.  Perfect competition graphs ▪ Moving down to the third graph, which depicts a firm earning a negative economic profit, we see the firm is now making an economic loss. ▪ The market price (P3) is below the ATC to the firm which is at C3. P3 is still equal the firm’s average revenue and marginal revenue (P3 = AR = MR). ▪ The profit maximised point (E3) is therefore below the breakeven point of the firm. The distance from C3 to P3 represents the loss per unit the firm is making. The shaded area (P3C3 M E3) reflects the loss to the firm. Calculation of economic profit and loss  Calculation of economic profit and losses for Firm A and Firm B ▪ Firms that produce and sell different quantities will have different results in terms of profit. ▪ In the short run, some firms will make economic profits, some will break even or make normal profits, and some will make economic losses. ▪ As an example, let’s look at two firms: Firm A and Firm B. Assume that Firm A is producing nine units, while Firm B is producing five units. The equilibrium positions of the two firms are depicted as follows. Calculation of economic profit and losses for Firm A and Firm B  Calculation of economic profit and losses for Firm A and Firm B ▪ Firm A is making economic profits. Its TR is R 270 (R 30 × 9), which is represented by the rectangle 09E130. The firm’s TC is R 225 (R 25 × 9), which is represented by the rectangle 025M9. This means that Firm A’s economic profit is R 45 (R 270 – 225), which is represented by the shaded rectangle 25ME130. ▪ Firm B, however, is making economic losses. Its TR is R 150 (R30 × 5), which is represented by the rectangle 05E330. The firm’s TC is R 200 (R 40 × 5), which is represented by the rectangle 05M40. This means that the firm is making economic losses of R 50 (R 200 – R 150), which is represented by the shaded rectangle 30E3M40.  The shutdown rule ▪ It is just as important to understand the supply of a firm, and the best way to do this is to first gain an understanding of the shutdown rule. ▪ This rule states that, in the short run, a firm should only produce a good when the total revenue (TR) is equal to or greater than the total variable cost (TVC); ▪ or in terms of individual units, the firm should only produce when the average revenue (AR) or price (P) in a perfectly competitive market is equal to, or greater than average variable cost (AVC). ▪ It is logical that in the long run a firm should only produce when the TR is sufficient to cover all its costs, as no firm would run at a loss in the long run.  The shutdown rule ▪ In the short run, the total fixed costs (TFC) are fixed no matter what output the firm produces so even if the firm produces an output of zero it will still have to pay its fixed costs. ▪ Therefore, if AR is greater than AVC the excess revenue will help to pay part of the FC, reducing the loss the firm is making in the short run. At the same time, if the AR is equal to the AVC, the firm would be no worse off than if it produced an output of 0. ▪ Thus, it is believed that a firm will start producing if the AR is equal to or greater than the AVC or if TR is equal to or greater than TVC. ▪ The firm would continue producing even though it is making a loss, with the goal that in the long run there will be a change in variable cost or the price of the good and the firm will be able to make a normal economic profit. The firm will also ensure that it retains its staff and customers.  The shutdown rule ▪ By continuing to produce in the short run, the costs of shutting down and later restarting production would outweigh the costs of continuing production and running at a loss in the short run. ▪ However, if the AR is less than AVC or TR is less than TVC, the firm will shut down as it will be incurring more of a loss by continuing to produce.  The shutdown rule ▪ As shown in the graph, both firms are making economic losses. Firm 1’s total revenue is R 200 (R 10 × 20), and its total cost is R 300 (R 15 × 20). This gives a loss of R 100 (R 300 – R 200). Firm 2’s total revenue is R 150 (R 10 × 15), and its total cost is R 300 (R 20 × 15). Therefore, Firm 2 makes a loss of R 200. ▪ To determine which firm must continue operating and which one must cease operations, we can use the shutdown rule. Remember, this rule states that a firm should close only if it fails to cover its total variable costs, or if the average revenue or price is less than the average variable cost. ▪ Firm 1’s total variable cost is R 100 (R 10 × 10), which is equal to its total revenue – i.e., TR = TVC. This means that Firm 1 is covering its variable cost and, therefore, must continue operating. Alternatively, you can also see that Firm 1’s average revenue is R 10, and this is also the value of its AVC. As such, the decision remains the same. ▪ Firm 2’s total variable cost is R 180 (R 12 × 15). This is higher than its total revenue, which stands at R 150. Since TR < TVC, Firm 2 must shut down, as it is not covering all of its variable costs. From the graph, it is also clear that its average variable cost of R 12 is greater than the average variable, which is R 10. ▪ It is important to note that the shutdown rule applies to all market structures. In other words, any firm that fails to cover variable costs must shut down, irrespective of whether it is a monopoly, oligopoly or monopolistically competitive. The supply curve of a perfectly competitive firm  The supply curve of a perfectly competitive firm ▪ The graph above shows the marginal cost (MC) curve of a firm in a perfectly competitive market as well as various demand curves at different prices. ▪ It can be seen that at some point a firm will stop producing, as the AR is below the AVC. Point b on the graph is the shutdown point, as this is where AR is equal to AVC. ▪ We know that the firm will start to produce at point b and continue to produce as we move up along the MC curve. Therefore, we can say that the MC curve of a perfectly competitive firm is the supply curve once it is above the AVC. This is because the marginal cost curve tells us what quantity of the product the firm will produce at various prices, which is essentially the supply curve.  The supply curve of a perfectly competitive firm ▪ It is important to note that in a perfectly competitive market, a profit- maximising firm will produce where MR = MC. We can also say that a profit-maximising firm will produce where P = MC. ▪ Remember that in perfect competition, P = MR. Given that MR = MC at a profit-maximising output level, it can be derived that a perfectly competitive firm will maximise profit where P = MC. Now, the MC curve is equal to the supply curve of the perfectly competitive firm. We also know that the MR curve is equal to the demand curve. ▪ Therefore, the firm will produce where the supply curve meets the demand curve. This will provide the firm with the quantity of the product that it must produce. If the firm is producing at a point where MR does not equal MC, the following steps must be taken to increase profit (BCcampus, n.d.):  The supply curve of a perfectly competitive firm When MR > MC, quantity/output should be expanded to increase profits When MR < MC, quantity/output should be reduced to increase profits When MR = MC profit is being maximised Long run equilibrium of the firm in a perfectly competitive market ▪ In the long run, two things can change in a perfectly competitive market. ▪ Firstly, new firms can enter or exit the market, as a condition for perfect competition is free entry and exit. ▪ Secondly, a firm may try to increase its profits by increasing its output to take advantage of economies of scale. ▪ Equilibrium will occur in the long run when the price in the market is sufficient for all the firms to earn a normal economic profit.  Monopoly ▪ According to Pal (n.d.), a monopoly exists when a firm is the sole supplier of a product that is unique. The product does not have any close substitutes. ▪ Entry into the market is prohibited by various types of barriers to entry, and this means, for the monopolist, that there is no competition in both the short and long term. ▪ The monopolist can decide to raise its prices without having to consider the possibility of its competitors charging a lower price and capture market share. ▪ The monopolist has total control over the supply of the product, which means that the firm’s individual supply is equal to the industry supply, since there are no competitors. The monopolist also has complete discretion over the price of the product.  Monopoly ▪ The firm is a price-setter, in direct contrast with perfectly competitive firms, which are all price-takers. Monopoly is, however, not without limits. One factor limiting the price-setting power of monopolies is consumer demand. ▪ The monopoly cannot charge whatever price it desires. The demand curve facing the firm is given by the average revenue (AR) curve of the firm. The profit maximising condition of a perfective competition applies to monopoly. ▪ Hence, the monopolist will maximise profits where marginal revenue is equal to marginal cost: MR = MC. The following figure illustrates the short- run and long run equilibrium position of a monopolist. Short-run and long-run equilibrium of a monopoly  Short-run and long-run equilibrium of a monopoly ▪ Let’s first consider why the firm is supplying a quantity of Q1. If the monopoly firm were to produce less than Q1, marginal revenue (MR) would be higher than marginal costs (MC). ▪ This would mean that the firm has the potential to earn more. If the firm were to produce and sell more than Q1, the marginal cost of producing an extra unit of output would be more than the marginal revenue that additional unit would bring into the firm. Thus, any point after Q1 would not be profitable for the firm, and profit maximisation would be at the point where marginal cost equals marginal revenue (E). ▪ The profit maximisation point, where marginal cost equals marginal revenue is where equilibrium is reached. Firms will maximise profits when they produce output at this point; this holds true for both the short and long run.  Short-run and long-run equilibrium of a monopoly ▪ Now let’s consider why the price is set so high above the profit maximisation point. The monopoly will produce Q1 and charge consumers the corresponding price, which is derived from the demand curve, Point M1. ▪ Recall that the demand curve illustrates the highest price that consumers are willing and able to pay for different quantities. The corresponding price for Q1 is P1. It is important to note that P1 is quite high above the marginal cost and average total cost (C1), providing the firm with a large profit represented by the shaded area C1P1M1K1. K1 shows where the average total cost (ATC) per unit of output is when a quantity of Q1 is produced, and M1 shows where the average revenue (AR) per unit of output is when a quantity of Q1 is produced. Since M1 is above K1, ▪ this tells us the average revenue earned per unit of output is more than the average total cost, again showing us that the firm is making an economic or abnormal profit. Short-run and long-run equilibrium of a monopoly ▪ It is important to remember that just because a firm has a monopoly in a market does not guarantee that it will make an economic profit, or even break even. If a monopoly firm is selling product that no-one wants, or is charging too much, it will not be profitable.  Monopsony ▪ A monopsony occurs when there is only one buyer in the market, and therefore the single buyer has power over the price of the product and can force prices lower. ▪ Where in a monopoly there is only one supplier and many buyers, in a monopsony there is only one buyer and many suppliers. The buyer can negotiate with the suppliers to ensure that they get the best price possible. ▪ However, it is important to realise that the firm will never produce goods at an economic loss in the long run, thus the market power of the buyer is limited to some degree.  Oligopoly ▪ An oligopoly is a market in which only a few firms compete. Products may be homogeneous (referred to as a pure oligopoly) or heterogeneous (referred to as a differentiated oligopoly). ▪ Products may therefore be identical, or they may differ. Examples of goods sold in a pure oligopoly would be steel, copper, gold and cement, while products produced in a differentiated oligopoly would include cars, cigarettes, household appliances and airplanes. ▪ The main feature of this market is that entry and exit are not free – there are barriers that restrict entry to the market. Barriers could include high entry costs such as patented production techniques, or strong reputations built up over time. ▪ A good example of an oligopoly is the car industry, as there is a limited number of firms that produce cars. The reason for this is the high cost of entering the market – you cannot simply decide overnight that you would like to start producing cars, as a large investment as well as significant research is required to enter this market.  Oligopoly ▪ As only a few firms are competing in the market, these firms tend to have market power and are therefore able to influence the market price. ▪ They do not, however, enjoy the same market power of a monopoly, as they will face competition from the other firms in the market. Due to the low number of firms competing in this market, there is a high degree of interdependence between the firms. ▪ This means that all the firms in the market have a considerable effect on each other and the actions of one firm will directly affect the others. This can lead to collusion between firms. ▪ Collusion is illegal in South Africa and these markets are closely monitored by competition authorities to ensure this does not take place.  Oligopoly ▪ When we study a market, we usually want to determine the price and quantity that prevail in equilibrium. When we look at a firm’s equilibrium quantity and price in an oligopoly, it is affected by the behaviour of competitor firms. ▪ At the same time, the competitors’ decisions depend on the behaviour of the first firm. Therefore, each firm must not only try and do the best it can possibly do but should also take into consideration the actions of other firms in the market.  Monopolistic competition ▪ A monopolistic competitive market is similar to a perfectly competitive market, with three major similarities – there are many firms in the industry, all firms earn normal profits in the long run, and there is free entry and exit to the market. ▪ It differs from a perfectly competitive market as the product is believed to be differentiated (heterogeneous). Therefore, each firm sells a product that can differ in quality, reputation and appearance. ▪ Each firm is also the only producer of its particular product; it can be said to have a ‘monopoly’ in producing its own particular product. However, this differs from a monopoly as there are a large number of close substitutes available for the product.  Monopolistic competition ▪ A good example of this is the market for bottled water. Each firm sells a very similar product, but individual bottles could differ in size, and it is often assumed that they differ in quality based on whether the water is from a natural spring or if it is merely purified. ▪ The amount of market power a firm has is dependent on how differentiated its product is from other products. Thus, firms are not price-takers. They do have some influence over the price, but the influence they have is not nearly as significant as that of a firm in an oligopoly or a monopoly.  Monopolistic competition In order for monopolistic competition to exist, the following conditions have to be met: Each firm must have a distinctly differentiated product; no two firms can sell identical products. Firms must face a downward-sloping demand curve (as opposed to a horizontal demand curve in a perfectly competitive market). This shows that the firm has some market power. There must be a large number of buyers and sellers in the market to ensure that the market remains competitive. There must be free entry and exit to the market, so no barriers to entry must exist. Monopolistic competition  Monopolistic competition ▪ Similar to monopolists, firms will produce and are said to be in equilibrium where their marginal revenue is equal to their marginal cost (point E on the graph above); in the long run, this is where firms make a normal profit. ▪ The long run profit maximizing quantity is thus Qe, where firms charge a price per unit of Pe. As you can see from the graph, the equilibrium price is set where the average revenue curve is tangent to the average total cost curve. ▪ In the short run when price is higher than average total cost firms experience an economic profit, other firms see this and are then enticed to enter the market. ▪ They are able to do so due to the fundamental characteristic of the monopolistically competitive market that is that there is free entry and exit, contrast to a monopoly market, which has high barriers to entry. ▪ When more firms enter the market they drive the price down until, in the long run, it equals average total cost and long-run equilibrium is reached.  Monopolistic competition ▪ Here all firms experience normal profits only. It is important to note that the demand curve for a monopolistically competitive market is significantly more elastic than that of a monopolist due to the fact that in the long run, with more entrants in the market, there are many close substitutes. ▪ Monopolistic competition results in some inefficiencies, but the cost of these may be outweighed by the benefits that monopolistic competition provides to the economy.  Monopolistic competition ▪ When comparing the long-run equilibrium positions of perfectly competitive and monopolistically competitive firms, there are two sources of inefficiency in a monopolistically competitive market (Lumen Learning [b], n.d.): 1. Allocative inefficiency: The condition for allocative efficiency is that price must be equal to marginal cost – i.e., P = MC. Unlike the perfectly competitive firm that sets its price equal to marginal cost, the monopolistically competitive firm’s price exceeds the marginal cost. This is due to the individual firms having some market power, and not simply being price-takers. This results in a higher price for consumers. 2. Productive inefficiency: The condition for productive efficiency is that a firm must operate on the minimum point of the average total cost. The monopolistically competitive firm produces at a point where its output is below the point that minimises average total cost.  Monopolistic competition ▪ Therefore, the firm is not producing efficiently, as it could produce goods at a lower cost. This inefficiency will have a negative effect on the economy as a whole, as the higher costs are relayed to consumers in the form of higher prices ▪ These inefficiencies make consumers slightly worse off, yet they are not completely socially undesirable and should not be regulated for two reasons: 1. In a monopolistically competitive market, market power is small, and firms are usually still able to compete. No single firm has much market power and therefore firms have fairly elastic demand curves with little market power; average total costs will be close to their minimum. 2. The inefficiency in the market is almost balanced out by the benefit of choice for consumers and product diversity. Imagine living in a world where all goods where identical – everyone would drive the same car, wear the same clothes and eat the same food.  Monopolistic competition ▪ Monopolistically competitive firms, oligopolists and monopolies all differ from perfectly competitive firms in that they are not price-takers. They have some market power. ▪ It is important to distinguish between market power and monopoly power. ▪ Market power is simply the ability of a firm to set price above its marginal cost. In this way, all price-setters have market power. Therefore, the greater the difference between price and marginal cost, the higher the degree of market power.  Monopoly power, also known as unilateral market power, refers to the market power that a monopoly (or one dominant firm) has. We can say that monopoly power means having complete control over the price, while market power signifies varying degrees of control over the price. As such, it is market power that leads to allocative inefficiency. In this way, perfect markets are the only efficient markets, because individual firms do not have market power.  Monopolistic competition ▪ What causes some firms to have significant market power and others to have none? There are three main factors that determine a firm’s market power within a market: 1. Elasticity of demand: A perfectly competitive firm’s demand curve is perfectly horizontal – i.e., it is a perfectly elastic demand curve, as the firm is a price-taker and has no degree of market power. A monopolistically competitive firm, on the other hand, has limited market power, as many substitutes exist. As a result, the demand curve of a monopolistically competitive firm will have a downward slope, but it will be more elastic. ▪ A monopoly produces goods with no close substitutes. Since the product is unique, the market demand curve of a monopoly is more inelastic. You will recall from Chapter 5 that if demand is inelastic, a firm can increase the price of its goods and, as such, increase total revenue. It is therefore profitable for a monopoly to charge higher prices, given that it has total market power. 2. Barriers to entry: A perfectly competitive and monopolistically competitive market are characterised by the absence of barriers to entry. As we already know, a perfectly competitive firm is a price-taker and has no market power. The degree of market power that a monopolistically competitive firm has will diminish over time, given the absence of barriers to entry. If a monopolistically competitive firm makes an economic profit, the profit will attract new firms to the market and increase competition between the firms, thereby lowering the degree of market power. On the other hand, oligopolies and monopolies are characterised by high barriers to entry or completely blocked entry. This implies that if these firms abuse their market power by setting excessive prices, the barriers to entry will protect them from possible entrants. The existence of barriers to entry therefore contributes to the degree of market power that a firm holds. 3. The interaction amongst firms: Even if there are only two firms in an industry, the market power of a firm may be low if there is a strong rivalry among the firms. The firms will be unable to increase the price, and subsequently their profitability, if there is an aggressive rivalry among them, with each firm trying to attract the largest market possible. These firms can, however, get together and fix prices, which would give them a lot of market power, known as cooperative or coordinated market power. When rival organisations get together and work as a unit, they are said to have formed a cartel. All actions of a cartel come out of collusion, which means that organisations will consult and agree on what to do. However, this practice is illegal in most countries. In South Africa, cartel formation is prohibited, as stated in Section 4 of the Competition Act 89 of 1998. The Competition Commission is responsible for regulating the activities of organisations in less competitive markets.  Monopolistic competition ▪ As you may have already inferred, the formation of a cartel and strength of coordinated market power depends on the pre-existing distribution of market share. For example, consider a market that consists of five organisations, each of which hold a 20% market share. ▪ This even distribution of market share among the organisations is an indication of strong rivalry. In such a case, the formation of a cartel is effective in eliminating rivalry and the uncertainty associated with mutual interdependence. ▪ In essence, a cartel formed by these organisations will give absolute cooperative market power. Now, suppose that the situation is that one of the five organisations , Organisation A, is dominant, with 90% market share, while the other four organisations share the remaining 10% share of the market equally. In this case, Organisation A has unilateral market power and can act solely, as if it were a monopoly. Comparison of markets