Now, we will consider another aspect of marketing – market structures. We will start the topic this week and continue it next week.
This refers to market classification according to the number of firms in the industry, types of product, the existence or non-existence of barriers to entry and the level or degree of competition.
There are four main market structures:
- Perfect competition
- Monopolistic competition
For each market structure the candidate should know the following:
- Short-run and long-run profits
ü Perfect competition
Definition: Perfect competition refers to a market structure in which there are numerous firms in the industry each selling a homogeneous product. There are no real examples of perfect competition in real life. However, some markets approach near to perfection. These include agricultural markets, stock markets and markets for foreign exchange.
Characteristics: Some of the key characteristics of perfect competition are:
Numerous buyers and firms in the industry: This means that neither one firm nor one buyer can affect the price in the market. Each is a price-taker.
The product being sold is homogeneous: This means that there are no differences in what each firm is selling, whether real or imagined. Thus, if a firm increases its price, its sales will fall to zero as the buyers will buy from the other sellers who have exactly the same product.
Perfect knowledge of the market: Both buyers and sellers know exactly what is happening in the market. For example, if prices change they are immediately aware of it.
Perfectly elastic demand curve: This indicates that the firms cannot control price, but can sell any amount at the ruling price.
Firms are independent: This means that they do not take into consideration what the other firms in the industry do.
Very high levels of competition: Competition among firms is due to the fact that there are numerous firms selling exactly the same product, each competing for the same consumer demand.
No advertising: Advertising is not necessary since every firm sells the same thing. In the space of competitive and persuasive advertising there may be a small amount of informative advertising.
We will now discuss the advantages and disadvantages of this market structure even though, in the strictest sense, this market structure does not exist in reality. Bear in mind, however, that the whole question of good and bad is relative.
Advantages of perfect competition
- All buyers and sellers are treated equally.
- There is only one price ruling in the market at a time and this price is not determined by any single buyer or seller but by the market forces of demand and supply.
- Competition keeps prices lower than under other market structures.
- Since the product is homogenous, sellers do not have to spend money on advertising.
- Competition between firms also forces them to be efficient.
- Firms under perfect competition respond to changes in consumer demand, therefore, the consumer is said to be sovereign or king.
Disadvantages of perfect competition
- Lack of variety because an undifferentiated good is produced.
- They may not be able to afford the technology that allows them to be efficient.
- The number of firms in the industry makes it impossible for them to benefit from collusion.
- There may be frequent changes in price as the market forces of demand and supply change.
Let us now consider the possible profits that can be earned in the short run and in the long run under perfect competition.
In the short run, some of the firms will earn normal profit, some will earn supernormal profit and some will earn subnormal profit.
Normal profit is that level of profit which is just enough to keep a firm in the industry. Once they are earning this level of profit, they will not leave the industry. In this situation, average revenue (AR) is equal to average cost (AC). This level of profit is often referred to as zero-economic profit.
If supernormal profits are being earned, this is so because AR is greater than AC. When AC is above AR or AR below AC, the firm is earning subnormal profit.
Consult an economics textbook to see how these levels of profit are illustrated graphically.
In the long run, all the firms under perfect competition will be in the situation where they are earning just normal profit AR=AC.
Just how did this come about?
In the long run, all the firms that had been earning subnormal profit in the short run AR<AC will leave the industry and will go into industries where they can at least earn normal profit.
When these firms leave, supply will fall and prices and profits will rise.
The firms that are earning supernormal profits AR>AC will attract other firms into the industry by their attractive level of profits.
As firms enter, supply will increase and prices and profits will fall. This rise and fall in profits will continue until all firms in the industry will be earning normal profit, AR=AC.
When this occurs, there will be no more incentives for firms to either enter or leave the industry. Thus the industry will be in long-run equilibrium. Again, the graphical illustration of this situation can be found in most economics texts.
Well folks, that is it for today. Next week, we will outline another market structure – monopoly.
You can begin to read up on this structure based on the headings I gave you in last week’s lesson. We will learn some interesting facts about this market structure and some common myths will be explained and dismissed. See you, then.
Definition and examples of monopoly
A pure monopoly is a market structure where there is only one firm in the industry, therefore, the firm is the sole supplier of that good or service. However, in the case where a firm controls approximately 20 per cent of a large market, it is considered a virtual monopoly.
Examples of monopolies in Jamaica:
- The Jamaica Public Service Company
- The National Water Commission
Characteristics/features of monopoly
1. As indicated in the definition, there is only one firm in the industry. The importance of this is that the demand curve for the firm’s goods or services will be relatively inelastic, allowing the monopolist to exercise his monopolistic power and restrict quantity, causing prices to rise substantially. Consumers will either have to pay the higher price or go without the goods or services altogether.
2. There are strong barriers to entry. A barrier to entry is anything that prevents a firm from entering an industry in the long run. Barriers to entry in this case would include things such as legal protection and government restrictions. The importance of strong barriers to entry is that in the long run, new firms will be kept out of the industry.
3. Monopolies are price-makers or fixers. Since they face downward sloping demand curves, they can choose what price to charge. However, they are still constrained by the demand curve in that, having decided on price, they must allow the demand curve to determine the quantity. A rise in price will lower the quantity demanded.
4. The product of the monopolist is unique, therefore, no close substitute for it is being produced by any other firm.
5. The monopolist may price discriminate, that is, charge people different prices for the same good and/or charge different unit prices for successive units bought by a given buyer. Those who price discriminate do so in order to earn increased profits.
It is likely that the monopolist will earn super-normal profits in the short run. Monopoly does not necessarily mean super-normal profits; some monopolies, at their profit-maximising output, face a situation where average cost is everywhere above average revenue. Thus, they are earning sub-normal (less-than-normal) profits.
Since there are strong barriers to entry, it is likely that if the firm were earning super-normal profits in the short run, it would maintain or continue to earn super-normal profits in the long run.
If the firm had been earning sub-normal profits in the short run, it would leave the industry in the long run and go into an industry where it can earn at least normal profits.
Your homework is the simple task of discussing the advantages and disadvantages of the monopolistic market structure. Remember, you can use economics texts to research this area.
You will recall from our last lesson that, in practice, there is no market which can be classified as perfectly competitive, though I did give examples of a market approaching near to perfection. Where pure monopoly is concerned, there are very few markets that can be classified as such in reality. Most markets, therefore, lie between these two extremes. In other words, most markets are either under monopolistic competition or oligopoly.
ü Monopolistic competition
This describes an imperfect market structure in which there are a relatively large number of producers offering slightly differentiated products.
Characteristics/features of monopolistic competition
1. A relatively large number of sellers. This makes the market highly competitive. In addition, each firm’s market share is small and collusion (coming together to act as a monopoly in order to gain more profits) is difficult.
2. Independence. Each firm acts independently of the others. That is, no firm takes into account the reaction of its rival firms.
3. Freedom of entry into the market and exit out of the market. In the long run, firms will enter and leave the industry due to the lack of significant barriers to entry.
4. The product is differentiated. Each individual seller has a product which is slightly different from the product of the other producers. This product differentiation is mainly through brand names, but can also be through physical and chemical differences.
5. Advertising takes place. Each seller seeks to increase brand loyalty for his/her product and thereby increase profits.
6. Firms are price makers/fixers. Therefore, their demand curve is downward sloping. It is also fairly elastic because of the relatively large number of firms in the industry.
Examples of monopolistic competition in the Caribbean: hairdressers, restaurants, taxi drivers and gas stations.
The short-run profits situation is similar to that of the perfect competitor. It is possible to earn supernormal profits. Subnormal and normal profits are also possible.
In the long run, the similarity between perfect competition and monopolistic competition becomes more obvious. Through entry of new firms and exit of some existing firms, profit will tend towards normal in the long run for all the firms in the industry.
We move on now to yet another market structure, oligopoly.
Oligopoly refers to a market structure in which a few firms dominate the industry in the sense that between them they share a large proportion of the industry’s output. Some oligopoly firms produce virtually identical products (for example metals, chemicals, sugar) and are known as perfect oligopolies, and some produce differentiated products (for example, cars, soap powder, cigarettes, electrical appliances) and are known as imperfect oligopolies.
Duopoly is a special form of oligopoly in which there are only two firms in the industry.
Characteristics/ features of oligopoly
1. There are only a few firms in the industry. With only a few firms in the industry, each is big enough to influence price. Firms are, therefore, price makers/price fixers.
2. Interdependence of firms. Since there are only a few firms in the industry, each firm will have to take into account the actions of rival firms in the industry, for example, if one airline announces discount fares, generally, all the other airlines will try to match the lower prices.
3. The product is either identical or differentiated. Where the product is identical, there is no need for advertising or non-price competition. However, if the product is differentiated, advertising and non-price competition will take place in order to make consumers believe that one brand is better than the other.
4. There are barriers to entry. These barriers may not be as strong as the barriers for the monopolist; however, the effect is still the same. Barriers will make it virtually impossible for others to enter in the long run.
5. Prices tend to be stable. This is because firms realise that decreases in price can lead to ‘price wars’ and they can end up losing so much profit that they are eventually driven out of the industry. They also know that raising prices will be of no advantage to them since others will not copy them.
6. Firms may be collusive or non-collusive. When they are collusive, they may, for example, formulate an agreement to set prices for everyone at a certain level.
7. Oligopolies may price discriminate in order to earn more profit.
Profits in the short-run
Like the monopolist, many oligopolistic firms will earn supernormal profits in the short run.
If the barriers to entry are strong, supernormal profits will be maintained. Where a firm is earning less-than-normal profits in the short run, it will leave the industry in the long run.
Now for your practice question:
(a) Define ‘monopolistic competition’ and ‘oligopoly’.(4 marks)
(b) Compare the market structures named in (a) above, under the following headings:
(i) the number of firms in the industry
(ii) the existence or non-existence of barriers to entry
(iii) type of product (6 marks)
(c) Give TWO examples of oligopoly industries and TWO examples of monopolistic industries in the Caribbean. (4 marks)
(d) “A monopolistic firm is earning supernormal profits in the short run.” What do you understand by this statement? (2 marks)
(e) Assume that firms under monopolistic competition and oligopoly are earning supernormal profits in the short run:
(i) How will their long-run profits differ?
(ii) Give reasons for the differences in their long-run profits. (4 marks)
Total marks: 20
This completes market structures. I urge you to do some reading on the topic. You will find some interesting facts if you consult texts in economics.