PhD Macroeconomics question
Fire 2
TheoryofFirm.docxTheory of Firm: Market Structures
We will study about types of major market structures, their characteristics and price determination.
Market structure refers to the nature and degree of competition in the market for goods and services. The structures of market both for goods market and service (factor) market are determined by the nature of competition prevailing in a particular market.
Based on competition, a market can be classified in the following ways:
1. Perfect Competition: A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect competition is a market structure characterized by a complete absence of rivalry among the individual firms.” According to R.G. Lipsey, “Perfect competition is a market structure in which all firms in an industry are price- takers and in which there is freedom of entry into, and exit from, industry.”
Characteristics of Perfect Competition
· Large Number of Buyers and Sellers
· Freedom of Entry or Exit of Firms
· Homogeneous Product
· Absence of Artificial Restrictions
· Profit Maximization is the final Goal
· Perfect Mobility of Goods and Factors
· Perfect Knowledge of Market Conditions
· Absence of Transport Costs
· Absence of Selling Costs
Difference between Perfect Competition and Pure Competition
Perfect competition is often distinguished from pure competition, but they differ only in degree. The first five conditions relate to pure competition while the remaining four conditions are also required for the existence of perfect competition. According to Chamberlin, pure competition means, competition unalloyed with monopoly elements,” whereas perfect competition involves perfection in many other respects than in the absence of monopoly.” The practical importance of perfect competition is not much in the present times because few markets are perfectly competitive except those for staple food products and raw materials. That is why, Chamberlin says that perfect competition is a rare phenomenon.”
2. Monopoly: According to D. Salvatore, “Monopoly is the form of market organization in which there is a single firm selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself an industry and the monopolist faces the industry demand curve.
Characteristics of Monopoly
· One producer or seller of a particular product and there is no difference between a firm and an industry. A monopoly may be individual proprietorship or partnership or Joint Stock Company or a cooperative society or a government company.
· A monopolist has full control over the supply of a product. Hence, the elasticity of demand for a monopolist’s product is zero.
· No close substitute for a monopolist’s product in the market. Hence, the cross-elasticity of demand for a monopoly product with some other goods is very low.
· Barriers to entry.
· A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
· Pure monopoly is not found in the real world.
· Demand curve slopes downwards to the right. Marginal revenue curve of a monopolist is below the average revenue curve, and it falls faster than the average revenue curve. This is because a monopolist must cut down the price of his product to sell an additional unit.
3 . Oligopoly: Oligopoly market structure comprises a few firms selling homogeneous or differentiated products. It is difficult to pinpoint the number of firms in ‘competition among the few.’ With only a few firms in the market, the action of one firm is likely to affect the others. An oligopoly industry produces either a homogeneous product or heterogeneous products. The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated oligopoly. Pure oligopoly is found primarily among producers of such industrial products as aluminum, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among consumer goods such as automobiles, cigarettes, soaps and detergents, TVs etc.
Characteristics of Oligopoly
· Interdependence: There is recognized interdependence among the sellers in the oligopolistic market. Each oligopolistic firm knows that changes in its price, advertising, product characteristics, etc. may lead to countermoves by rivals. When the sellers are a few, each produces a considerable fraction of the total output of the industry and can have a noticeable effect on market conditions.
· Advertisement: The main reason for this mutual interdependence in decision making is that one producer’s fortunes are dependent on the policies and fortunes of the other producers in the industry, according to Prof. Baumol, “Under oligopoly advertising can become a life-and-death matter.”
· Competition: Since there are few sellers, a move by one seller immediately affects the rivals. So, each seller is always on the alert and keeps a close watch over the moves of its rivals to have a countermove. This is true competition.
· Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit from it. However, in the long run, there are some types of barriers to entry which tend to restrain new firms from entering the industry. This is because of:
(a) Economies of scale (b) control over essential and specialized inputs(c) high capital requirements due to plant costs, advertising costs, etc. (d) exclusive patents and licenses; and (e) the existence of unused capacity which makes the industry unattractive. When entry is restricted or blocked by such natural and artificial barriers, the oligopolistic industry can earn long-run super normal profits.
· Lack of Uniformity: There is a lack of uniformity in the size of firms. This is very common in the American economy. A symmetrical situation with firms of a uniform size is rare.
· Demand Curve: It is not easy to trace the demand curve for the product of an oligopolist.
This situation is shown in Figure 1 where KD1 is the elastic demand curve and MD is the less elastic demand curve. The oligopolies’ demand curve is the dotted kinked KPD. The reason is quite simple. If a seller reduces the price of his product, his rivals also lower the prices of their products so that he cannot increase his sales.
The oligopolies' demand curve
So, the demand curve for the individual seller’s product will be less elastic just below the present price P (where KD1and MD curves are shown to intersect). On the other hand, when he raises the price of his product, the other sellers will not follow him to earn larger profits at the old price. So, this individual seller will experience a sharp fall in the demand for his product. Thus, his demand curve above the price P in the segment KP will be highly elastic. Thus, the imagined demand curve of an oligopolist has a comer or kink at the current price P. Such a demand curve is much more elastic for price increases than for price decreases.
· No Unique Pattern of Pricing Behavior: The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Each wants to remain independent and to get the maximum possible profit. Towards this end, they act and react on the price-output movements of one another in a continuous element of uncertainty.
4. Duopoly: Duopoly is a special case of the theory of oligopoly in which there are only two sellers. Both the sellers are completely independent, and no agreement exists between them. Even though they are independent, a change in the price and output of one will affect the other and may set a chain of reactions. A seller may, however, assume that his rival is unaffected by what he does, in that case he takes only his own direct influence on the price.
5. Monopolistic Competition: Monopolistic competition refers to a market situation where there are many firms selling a differentiated product. “There is competition, which is keen, though not perfect, among many firms making very similar products.” No firm can have any perceptible influence on the price-output policies of the other sellers, nor can it be influenced much by their actions. Thus, monopolistic competition refers to competition among a large number of sellers producing close but not perfect substitutes for each other.
Characteristics of monopolistic competition
· Large Number of Sellers
· Product Differentiation
· Freedom of Entry and Exit of Firm
· Nature of Demand Curve: No single firm controls more than a small portion of the total output of a product. No doubt there is an element of differentiation, nevertheless the products are close substitutes. As a result, a reduction in its price will increase the sales of the firm but it will have little effect on the price-output conditions of other firms, each will lose only a few of its customers. Likewise, an increase in its price will reduce its demand substantially but each of its rivals will attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a firm under monopolistic competition slopes downward to the right. It is elastic but not perfectly elastic within a relevant range of prices of which he can sell any amount.
· Independent Behavior: Every firm has independent policy.
· Product Groups: There is not any ‘industry’ under monopolistic competition but a ‘group’ of firms producing similar products. Each firm produces a distinct product and is itself in industry. Chamberlin lumps together firms producing very closely related products and calls them product groups, such as cars, cigarettes, etc.
· Selling Costs: Under monopolistic competition where the product is differentiated, selling costs are essential to push up sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers for window displays, free service, free sampling, premium coupons and gifts, etc.
· Non-price Competition: A firm increases sales and profits of its product without a cut in the price. The monopolistic competitor can change his/her product either by varying its quality, packing, etc. or by changing promotional programs.
Comparing Table
Source: Market Structure: Meaning, Characteristics and Forms | Economics (yourarticlelibrary.com)
Price determination under Perfectly Competitive Market
a. Mathematical Derivation of the equilibrium of the firm
The firm aims to maximize its profit
Π = TR – TC
Where π = profit, TR = total revenue and TC = total cost
Clearly, TR = f(Q) and TC = f(Q), given the price (P).
· The first-order condition for the maximization of function is that its first derivative (with respect to Q in our case) be equal to zero.
=
The term ∂TR/∂Q is the slope of the TR, that is, Marginal revenue (MR) and ∂TC/∂Q is the slope of the Total Cost curve, that is, Marginal Cost (MC). Thus, first-order condition for profit maximization is
MR = MC
Given that MC> 0, MR must also be positive at equilibrium. Since MR = P, the f.o.c. may be written as MC = P.
· The second-order condition for profit maximization requires that the second derivative of the function be negative (less than zero).
- < 0
Which yields the condition
<
(slope of MR) < (slope of MC)
Thus, the MC must have a steeper slope than the MR curve or the MC must cut the MR curve from below. In pure competition the slope of the MR curve is zero.
b. Graphical demonstration of Equilibrium of the firm
Fig: Equilibrium of the firm in short run
Because of free entry and exit, eventually firm operates under normal profit equating MC = MR = P in the long run.
Price determination under monopoly market
Fig. Price determination/equilibrium of the firm under monopoly
Comparing Monopoly and perfect competition ( book page 200)
Deadweight Loss
Deadweight loss, also known as excess burden, is a measure of lost economic efficiency when the socially optimal quantity of a good or a service is not produced. Of the many reasons, monopoly pricing is one that creates deadweight loss. In other words, it is the cost born by society due to market inefficiency.
In detail:
What is Deadweight Loss?
Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved. In other words, it is the cost born by society due to market inefficiency.
Causes of Deadweight Loss
· Price floors: The government sets a limit on how low a price can be charged for a good or service. An example of a price floor would be minimum wage.
· Price ceilings: The government sets a limit on how high a price can be charged for a good or service. An example of a price ceiling would be rent control – setting a maximum amount of money that a landlord can collect for rent.
· Taxation: The government charges above the selling price for a good or service. An example of taxation would be a cigarette tax.
Imperfect Competition and Deadweight Loss
Deadweight loss also arises from imperfect competition such as oligopolies and monopolies. In imperfect markets, companies restrict supply to increase prices above their average total cost. Higher prices restrict consumers from enjoying the goods and, therefore, create a deadweight loss.
Example of Deadweight Loss
Imagine that you want to go on a trip to Vancouver. A bus ticket to Vancouver costs $20, and you value the trip at $35. In this situation, the value of the trip ($35) exceeds the cost ($20) and you would, therefore, take this trip. The net value that you get from this trip is $35 – $20 (benefit – cost) = $15.
Prior to buying a bus ticket to Vancouver, the government suddenly decides to impose a 100% tax on bus tickets. Therefore, this would drive the price of bus tickets from $20 to $40. Now, the cost exceeds the benefit; you are paying $40 for a bus ticket from which you only derive $35 in value.
In such a scenario, the trip would not happen, and the government would not receive any tax revenue from you. The deadweight loss is the value of the trips to Vancouver that do not happen because of the tax imposed by the government.
Graphically Representing Deadweight Loss
Consider the graph below:
At equilibrium, the price would be $5 with a quantity demand of 500.
· Equilibrium price = $5
· Equilibrium demand = 500
In addition, regarding consumer and producer surplus:
· Consumer surplus is the consumer’s gain from an exchange. The consumer surplus is the area below the demand curve but above the equilibrium price and up to the quantity demand.
· Producer surplus is the producer’s gain from exchange. The producer surplus is the area above the supply curve but below the equilibrium price and up to the quantity demand.
Let us consider the effect of a new after-tax selling price of $7.50:
The price would be $7.50 with a quantity demand of 450. Taxes reduce both consumer and producer surplus. However, taxes create a new section called “tax revenue.” It is the revenue collected by governments at the new tax price.
With this new tax price, there would be a deadweight loss:
As illustrated in the graph, deadweight loss is the value of the trades that are not made due to the tax. The blue area does not occur because of the new tax price. Therefore, no exchanges take place in that region, and deadweight loss is created.
Calculating Deadweight Loss
To figure out how to calculate deadweight loss from taxation, refer to the graph shown below:
Notes:
· The equilibrium price and quantity before the imposition of tax are Q0 and P0.
· With the tax, the supply curve shifts by the tax amount from Supply0 to Supply1. Producers would want to supply less due to the imposition of a tax.
· The buyer’s price would increase from P0 to P1 and the seller would receive a lower price for the good from P0 to P2.
· Due to the tax, producers supply less from Q0 to Q1.
The deadweight loss is represented by the blue triangle and can be calculated as follows:
Price Discrimination
In the monopoly market structure, a discriminating monopolist may charge different prices to different segments of its customer base. An online retailer may charge higher prices to buyers in wealthy ZIP codes and lower prices to those in poorer regions. Airlines offer different prices for the same trip. Because in a monopoly there is only one firm, the firm's demand curve is the market demand curve. It is commonly used by larger, established businesses to profit from differences in supply and demand from consumers.
Types of price discrimination
There are three types of price discrimination: first-degree or perfect price discrimination, second-degree, and third-degree.
Fig: Third Degree Price Discrimination (Discrimination in Elastic and Inelastic demand and revenue collection)
Advantages of Price Discrimination
Advantages of this pricing strategy can be viewed from the perspective of both the firm and the consumer:
The Firm
· Profit maximization: The firm can turn consumer surplus into producer surplus. In a first-degree price discrimination strategy, all consumer surplus is turned into producer surplus. It also ties into survivability, as smaller firms can better survive if they are able to offer different prices in times of greater and lower demand.
· Economies of scale: By charging different prices, sales volume is likely to increase. As a result, firms can benefit from increasing their production towards capacity and utilizing economies of scale.
The Consumer
· Lower prices: Although not all consumers are winners, consumers that are highly elastic may gain consumer surplus from the lower prices, due to price discrimination. For example, at a movie theatre, tickets for seniors and children are typically priced at a discount to adult tickets.
Disadvantages of Price Discrimination
· Higher prices: As indicated above, some consumers will face lower prices while others will face higher prices. Consumers that face higher prices (i.e., consumers who purchase airline tickets during peak season) are disadvantaged.
· Reduction in consumer surplus: The pricing strategy reduces consumer surplus and transfers money from consumers to producers, leading to inequality.
Key Takeaways
· Price discrimination is a sales strategy for selling the same product or service to different customers for different prices.
· First-degree price discrimination involves selling a product at the exact price that each customer is willing to pay.
· Second-degree price discrimination targets groups of consumers with lower prices made possible through bulk buying.
· Third-degree price discrimination sets different prices based on the demographics of subsets of a client base.
· For price discrimination to work, businesses must prevent resale, must be able to operate in an imperfect market, and must demonstrate elasticities of demand.
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