Chapter 7: Market Structures

Market structures refer to factors such as the number of firms in the market , the ease at which firms enter or leave the market, the size of the firm, etc. which determine the behavior and performance of firms selling products in that market. A market in economics refers to a situation/context where potential sellers of a commodity are brought into contact with potential buyers and a means of exchange is available. There does need to be a physical entity corresponding to a market thus, for example, a market may be created over telephone or market.

Essentials of a Market

• Presence of commodities
• Presence of buyers
• An area/region must exist.
• Interaction between buyers and sellers.
• Existence of sellers
• A medium of exchange unless barter system is being applied.

Extent of a Market

The market may be wider or limited depending on area covered on selling commodities. The extent depends on;

• Nature of commodity-if the commodity is durable and valuable, the market will be wider and vice versa is true.
• Extent of demand-commodities with greater demand translates to wider market and the vice versa is true.
• Peace and security-during peace and security, commodities will be sold in large areas hence the market will be wider and vice versa is true.
• Means of transport and communication-if they are developed, it will be possible to move commodities from one place to another.
• Policies of the government which can either promote or restrict movement of goods.
• If the banking and monetary system of a county is more stable, there will be a wider market due to the facilitation made.

Functions of a Market

• To facilitate transactions by providing the opportunities of buying and selling goods
• It serves as an outlet of goods and services for various goods produced
• It is a source of supply to a society
• Facilitates contact between buyers and sellers
• Helps in determination of prices to be charged in a market through demand and supply forces in the market
• Influences increase or decrease in production depending on market demand of a product

Types of Market Structures

Market Structures are divided into the following types:

• Perfect competitive market
• Pure monopoly single supplier for the market
• Monopolistic competition market with firms producing differentiated products
• Oligopoly a few interdependent firms dominate the market
• Duopoly

Perfect Competition

Perfect competition refers to a market where many buyers and sellers are selling homogeneous/ identical products. It is common in the agricultural sector e.g. maize, egg.

Characteristics of Perfect Competitive Market Structure

• It is a market which has many buyers and sellers such that no single person can influence the market price and output.
• Products sold are homogeneous.
• There are no barriers to entry and exit of market.
• No government control e.g. no price control.
• Demand curve facing the firm is perfectly elastic. For example a small price increase in one firm causes a big decrease in demand
• Both buyers and sellers are price takers: no one can influence the market.
• Both buyers and sellers have perfect knowledge about the market. They know product price and quantity.
• There is perfect mobility of factors of production. Factors of production are free to move from none profitable activities to profitable activities.
• Firms are price takers

Market Demand and Individual Firm Demand Curve

Prices in this market are determined by the market forces of demand and supply. This is where demand and supply curve meet. There are many sellers such that no single sellers can influence the market price such that each seller must sell the product at market price.

In this case the market price is the individual firm price and the market demand curve is the individual firm represented by a horizontal straight line.

Equilibrium of a Perfect Competitive Firm

A firm maximizes profits or is at equilibrium when it produces the level of output at a point where MR = MC and as long as MC cuts MR from below. It is possible for a PC firm to make losses, abnormal profits or normal profits in the short run depending on the position of the AC curve. Firms in this market make normal profits in the long run.

 

The firm is at equilibrium when it produces the level of output at point at X where MR = MC and produces output Qe. At point X, AR = AC meaning TR = TC; TR – TC = O (normal profits)

Why normal profits are generated in the long run in perfect competitive market

Firms in this type of market structure at first make abnormal profits attracting many firms since entry is free. Supply increases and prices start decreasing and now firms start making losses. Losses force some firms to exit the market since exit is also free. This consequently reduces supply and prices start increasing such that in the long run firms are at equilibrium when they make normal profits. Normal profits are experienced when TR = TC meaning TR – TC = 0 (normal profits). At this point existing firms cannot quit the market and new firms cannot enter the market.

Advantages of Perfect Competition

• Consumers have choice in terms of many sellers to choose from
• No monopolies who may overcharge consumers by overcharging
• Entry is free
• Exit is free
• Competition among seller’s leads to production of high quality products enjoyed by consumers
• No wasteful competition.

Disadvantages of Perfect Competition

• Consumers lack variety of products because products are homogeneous.
• Stiff competition among firms causes weak firms to close down.
• Closing down of weak firms causes unemployment in the country.
• Firms make only normal profits in the long run.
• There is no room to produce public goods to benefit the public since the aim of the firm is to make profits.
• Since firms aim at making profits, they might not account for externalities. E.g. pollution.

Monopoly

A monopoly is a type of market structure having many buyers and one seller selling a product which has no close substitute and there are barriers to entry preventing other firms from entering the market.

Characteristics of a Monopoly

• Many buyers.
• One seller.
• There are barriers to entry. For example trade licenses.
• There is no direct competition from sellers since there is only one seller.
• Total control of essential resources or strategic resources.
• The government confers exclusive rights through issuance of ownership rights and especially through innovation / discovery.
• The firm experiences economies of scale.
• The government can grant one firm the exclusive right to operate – legal monopoly. E.g. water and electricity
• The firm is the price maker.

Sources of Monopoly Power

• Absolute ownership of raw material.
• Control over the marketing channel
• Economies of scale.ie low operating costs
• Government licensing to only some firms to supply some commodities KPLC
• High initial costs of starting the firm/industry. SAFARICOM
• Patent rights issued as a result of innovations. MICROSOFT
• Ownership of the rights of a well-known brand OMO, BLUEBAND
• Elasticity of market demand – Inelastic demand promotes monopoly
• Number of firms – monopoly decreases as no of firms increase
• Interaction among firms – Aggressive interactions promotes monopoly for some firms
• Legal barriers
• Possession of knowledge or techniques

Monopoly Demand Curve

Since there is only one seller or the good, the firms demand curve is in effect to the industry’s demand curve. For example the monopolistic demand curve is the market demand curve which is normally downward sloping. Therefore the monopolistic is not a price taker he will charge different prices at different

Because he faces a downward sloping Qd curve (AR curve), the monopolistic has to reduce the prices of all units sold in order to sell an extra unit of output. This implies that the MR must be less than the price.

Short run equilibrium

The aim of the monopoly is to maximize profits and this will be achieved when MC = MR. During the short run period, the market demand and costs of production will dictate how much a monopolistic will produce. At equilibrium a monopolistic will produce at a point where the short run marginal cost equals marginal revenue.

The monopolist misallocates resources because he adheres to the principle of MR = MC; but restricts output and charges more price than a perfectly competitive market. He also does not produce at the lowest point of ATC therefore does not gain productive efficiency. Also the monopoly does not have a supply curve because the same quantity is sold at market at different prices.

The long run equilibrium

In the long run, the monopolist has enough time to adjust output with change price. He can do this by building another plant or a smaller one depending on price and demand. At the long run a monopolistic will produce at a point where long run marginal cost is equal to long run marginal revenue.

If the total demand for the product does not change, the demand for any product of the firm will fall. This shifts the demand curve shifts to the left until the abnormal profits are eliminated and this point there are no incentives for new firms to enter the market.

Arguments for a Monopoly

• There is stability of output and prices than under competitive conditions.
• Enables the monopolist to spend on research and development. The invention of new techniques of production becomes possible.
• It is helpful to provide some services more smoothly and efficiently e.g. the network of electricity or water supply demands monopoly organisations.
• The establishment of monopoly is helpful to obtain the economies of scale
• The firm can reduce costs by standardizing his/her product and avoiding advertising expenses.

Arguments against Monopoly

• There is no optimal allocation of resources-e.g. kplc hence lack of competition.
• Consumers are likely to be overcharged in many cases because they lack any option.
• There is dead weight loss
• Price discrimination-ability of monopoly to charge different prices for the same good.
• A problem of quality of goods i.e. poor quality and issues of efficiency are compromised.
• The level of output is too low.it results in decrease in production and increase in unemployment.
• The monopolist can use his powers to restrict the entry of new firms and discourage the fair competition
• There is usually no freedom of choice as consumers are forced to get the product from producer and therefore have no freedom of choice.

Price discrimination under monopoly

A monopoly might charge different prices to different customer of similar goods and services in different markets in order to increase his profit levels and where price differences are not justified by cost differences.

Examples

• Airline companies/ trains charging different price to classes.
• Electricity utilities.
• International trade.

Conditions for price discrimination

• The seller must possess some degree of power in ability to control output and price.
• The monopoly must segment the market into distinct classes and charge different prices to each class
• The monopolistic must be aware of the willingness of the customers to pay for the products.
• The monopolistic must be able to protect resale of the product by buyers.

The price to charge in each market is dependent on the price elasticity of demand. In the first market where demand is price inelastic, he charges a higher price while selling lower quantity. In the second market where demand is price elastic, the price is lower and the quantity sold is higher.

Perfectly discriminating monopolistic (1 degree monopolistic)

The seller in this case charge the customer the highest price he or she is willing to pay.

The monopolistic demand and MR curves coincide because the monopolistic does not cut price on preceding units to sell more output. The most profitable output is at Q1 where MR = MC   but it is greater than that of nondiscrimination monopolistic.

NB:

• Perfect price discrimination results in greater profit and greater output than is the case of single price monopolistic.
• Some consumers pay more than the single price but others pay less.
• Perfect price discrimination and price competition are equally efficient.

Monopolistic Competition

Most markets have neither the single seller required to meet the definition of a pure monopolist nor the large number of small sellers and undifferentiated product necessary to qualify as perfectly competitive.

Monopolistic competition is a market where there are many firms producing similar but differentiated products with each firm having a limited degree of price control. E.g. designers, food industry (colgate ,aquafresh etc.).Monopolistic competition is a form of market in which there are many sellers of a heterogeneous or differentiated product and entry into and exit from the industry are rather eas’;y in the long run. Because of the differences among their products, firms in this market have some control over their price but it is usually small, because the products are close substitutes. The demand curve of a monopolistic competitive firm is highly elastic, but not perfectly elastic as in the case of perfect competition.

Monopolistic competition is most common in the retail and service sectors of an economy. Clothing, hair dressing, detergents and food processing are some of the industries that come close to monopolistic competition at the national level. At local level we can think of fast food outlets, beauty salons all located in close proximity to one another.

Short run price and output determination under monopolistic competition

The figure below shows the price and output determination under monopolistic competition. Since a monopolistically competitive firm produces a differentiated product that has close substitutes, the demand curve it faces is negatively sloped but highly price elastic. As in the case of monopoly, since the demand curve facing a monopolistic competitor is negatively sloped and linear, the corresponding marginal revenue curve is below it. The best level of output of the monopolistically competitive firm in the short run is given by the one at which MR=MC. This is shown by point E₁ on figure a. The optimal output is Q₁ while optimal price is P₁. The monopolistically competitive firm earns an economic profit presented by P₁CVA in the figure a below.

Short run and Long Run Price and Output Determination under monopolistic Competition

If firms in a monopolistic competition earn economic profits in the short run, more firms will enter the market in the long run. This shifts the demand curve facing each monopolistic competitor to the left (as its market share decreases) until it becomes tangent to the firm’s LAC curve.  Thus in the long run all monopolistically competitive firms break even (earn normal profit) and produce on the negatively sloped portion of their LAC curve (rather than at the lowest point, as in the case of perfect competition). This is shown in figure b above. The condition to be satisfied for profit maximization in the long run is MR=MC and P=AC.

Product differentiation Refers to a strategy designed to capture and retain particular market segments by producing a range of related products.  The products may be differentiated by packaging, design, content, chemical composition, advertising and other applicable forms. Perfect differentiation leads to a relatively elastic demand. Chamberlin argued that the demand for these products is affected by services associated with the product.

The firm maximizes profit by equating MC with MR hence selling at O P1. The firm makes supernormal profits equal to ABCP1.  The firm then retains or increases these profit levels by engaging in non-price competition e.g. advertisements and repackaging to make its products attractive to buyers.

Long run equilibrium

As long as the firm continues to make supernormal profits, new firms are induced to enter the industry. This leads to a fall in the demand of a single firm’s demand hence shifting the demand curve to the left until the supernormal profits are eliminated. At this point there are no incentives for other firms to enter the market.

Profit maximizing behavior of firms

Firms seek to maximize profits under normal circumstances.

Profits (π) = TR – TC

Conditions for profit maximization 1. Requires that the firms marginal revenue (MR) equal its Marginal cost (MC). MR = MC

Oligopoly

Oligopoly refers to the market structure that is dominated by large few firms. The number of sellers (firms) is small enough for other sellers to take account of each other i.e. if one seller changes his prices or uses non-price strategies his/her rivals would react. This is called oligopolistic dependency. Examples of this firms are, oil, motor vehicles and cigarette industries.

Characteristics of Oligopoly

• Contains few firms who produce goods that are substitute but need to be perfect substitutes.
• Lies somewhere between extreme of perfect competition are monopoly.
• There are barriers to the entry.
• Decision of the firms are strictly interdependent
• Sellers agrees on the price or the market share

Forms of oligopoly

• Duopoly where market is dominated by two firms
• Pure oligopoly where the products of the few sellers are identical.
• Differentiated oligopoly where products are differentiated in term of quality packaging etc.
• Collusive oligopoly where the few sellers in the market come together and make decisions to control the prices, quality and quantity to be produced.
• Non collusive oligopoly where the few sellers determine their prices, quality and quantity without colluding.

Kinked Demand Curve

The interdependence in oligopolistic firms explains the price rigidity among the firms. The theory of kinked demand curve suggests that firms in oligopoly face two sets of demand curves.

• Price increase
• Price reduction which is slightly inelastic

For price increases the firm is an elastic demand curve dd. For price decreases it is on the inelastic demand curve DD. This means the actual demand curve for firms is represented by dED. The demand is said to have a kink at point E associated with the price P1 and quantity Q1. All firms in the industry are assumed to be in a similar position which implies that if a firm raises its prices and its competitor fails to follow suits then, it will loss large sales of revenue. This firms is on the elastic portion of the demand curve. If one firm reduces prices, then its competitors will have to reduce their price by at least as much or even more to retain the market share. When the price is lower each firm has the same market share which implies that the firms are on the inelastic portion of the demand curve. Collusion will take the form of agreeing the prices for each market share. This is done in order for the oligopolistic firms to maximize their joint profits and reduce uncertainty. A form of open collusion is known as a cartel whereby firms produce differently but act like determinants of price and output.

Figure 5.8 shows the Equilibrium of an oligopolistic firm facing kinked demand curve. The marginal revenue is discontinuous at the output level where there is a kink in the demand curve. The kink in the demand curve explains the nature of the marginal revenue curve. Where at point E and output Q the marginal revenue curve falls vertically since at the higher price the marginal revenue curve correspond to less elastic demand curve. The firm maximizes its profit where the marginal cost is equal to marginal revenue. It is very likely that the marginal cost curve will cut the marginal revenue curve between point X and Y which corresponds to the discontinuous part of marginal revenue curve.

Ways of Controlling Power in Different Market Structures

• Through equitable distribution of resources where rich are taxed more than the poor.
• Through government regulations which limit expansion of some firms
• Through use of marketable permits that prevents competition.
• Protection from competition through giving specific firms patent rights
• Protection through giving firms copyrights
• Through giving subsidies by government to specific firms to promote their production.

Importance of Controlling Power in Market Structures

• To ensure consumers are not exploited through over pricing.
• To ensure goods are up to standards.
• To ensure that people involved in business comply with the law i.e. paying business permits, tax etc.
• To prevent overexploitation of resources due to low prices.
• To facilitate healthy competition.