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MARKET CLASSIFICATION
MARKET A market is any area over which buyers and sellers are in such close touch, either directly or through dealers, that the prices obtainable in one part of the market affect the prices paid in other parts.
Classification By Area
Local markets Regional Markets National Markets International Markets
Market Structure
Market Structure
The number of firms in the industry The nature of the product produced The degree of monopoly power each firm has The degree to which the firm can influence price Profit levels Firms behaviour pricing strategies, non-price competition, output levels The extent of barriers to entry The impact on efficiency
Market Structure
Perfect Competition Pure Monopoly
Market Structure
Perfect Competition Pure Monopoly
Market Structure
Perfect Competition Pure Monopoly
Monopolistic Competition
Oligopoly
Duopoly Monopoly
The further right on the scale, the greater the degree of monopoly power exercised by the firm.
Market Structure
Importance: Degree of competition affects the consumer will it benefit the consumer or not? Impacts on the performance and behaviour of the company/companies involved
Market Structure
Market structure deals with a number of economic models These models are a representation of reality to help us to understand what may be happening in real life There are extremes to the model that are unlikely to occur in reality They still have value as they enable us to draw comparisons and contrasts with what is observed in reality Models help therefore in analysing and evaluating they offer a benchmark
Market Structure
Number and size of firms that make up the industry Control over price or output Freedom of entry and exit from the industry Nature of the product degree of homogeneity (similarity) of the products in the industry (extent to which products can be regarded as substitutes for each other) Diagrammatic representation the shape of the demand curve, etc.
Market Structure
Characteristics: Look at these everyday products what type of market structure are the producers of these products operating in?
Electric Guitar Jazz Body Vodka
Remember to think about the nature of the product, entry and exit, behaviour of the firms, number and size of the firms in the industry. You might even have to ask what the industry is??
Perfect Competition
Large number of firms Products are homogenous (identical) consumer has no reason to express a preference for any firm Freedom of entry and exit into and out of the industry Firms are price takers have no control over the price they charge for their product Each producer supplies a very small proportion of total industry output Consumers and producers have perfect knowledge about the market
Perfect Competition
Diagrammatic representation
Cost/Revenue
MC AC
Givenaverage the cost ofis the Thethis industry price firm The MC is cost curve is the output the At The assumption of profit maximisation, shapedproduces standard U additional curve. producing theby the demand determined firm is(marginal) AC of MC industry making units of output. It at an cuts supply curve =profit. MC output where the atMR and the normal its This point long to thethe falls a output The of (Q1). asis first (due run alaw of lowest at whole. levelfirm is a This a because is diminishing relationship fraction of small supplier within mathematicaltotal industry rises very the position. equilibriumreturns) then asthe output rises. supply. industry and has no between marginal and average values. control over price. They will sell each extra unit for the same price. Price therefore = MR and AR
P = MR = AR
Q1
Output/Sales
Perfect Competition
Diagrammatic representation
Cost/Revenue
MC MC1 AC AC1
Because the model assumes perfect knowledge, makes Average and and MC firm The assume a firm thewould Nowlower ACMarginal costs gains that advantage nowlower could form of firm to be imply be the modification to some theexpected is for only a short timein the short run, form but price, or gains some its product before others copy earning abnormal profit the idea the same. remains or are attracted the (AR>AC) represented a new of cost advantage (saybyto the industry by grey area. method). What production the existence of abnormal profit. would happen? If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.
AC1
Abnormal profit
P = MR = AR P1 = MR1 = AR1
Q1
Q2
Output/Sales
Where the conditions of perfect competition do not hold, imperfect competition will exist Varying degrees of imperfection give rise to varying market structures Monopolistic competition is one of these not to be confused with monopoly!
Characteristics:
Large number of firms in the industry May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals products are therefore close, but not perfect, substitutes Entry and exit from the industry is relatively easy few barriers to entry and exit Consumer and producer knowledge imperfect
MC AC
1.00
Abnormal Profit
0.60
We assume that theQ1 and Marginal Cost equilibrium This is demandrunandfacing IfThe firm produces firm Since the additional the a short curve produces where willabeMC Average Cost in position forreceived1.00the sells firm willfirmdownward the each a be MR = on revenue unit for from (profit maximising output). same shape. falls, the the monopolistic market (on average with represents sloping and the cost each unit sold However, At because the products this output average) lies under the AR earned each unit being MR curve level, AR>AC structure. for from sales. and the firm makes in 40p x are differentiated 60p, curve. will make AR the firm abnormal profit (the grey some way, the firm Q1 in abnormal profit.will shadedbe able to sell extra only area). output by lowering price.
MR
Q1
D (AR)
Output / Sales
MC AC
Because there is relative freedom of entry and exit into the market, new firms will enter encouraged by the existence of abnormal profits. New entrants will increase supply causing price to fall. As price falls, the AR and MR curves shift inwards as revenue from each sale is now less.
MR1
Q1
MR
AR1
D (AR)
Output / Sales
MC AC
AR = AC
Notice that the existence of more substitutes makes the new AR (D) curve more price elastic. The firm reduces output to a point where MC = MR (Q2). At this output AR = AC and the firm will make normal profit.
MR1
Q2 Q1
MR
AR1
D (AR)
Output / Sales
MC AC
AR = AC
MR1
Q2
AR1
Output / Sales
Oligopoly
May be a large number of firms in the industry but the industry is dominated by a small number of very large producers
Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms:
A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry
Oligopoly
Example: Music sales
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.
Oligopoly
Price may be relatively stable across the industry kinked demand curve? Potential for collusion Behaviour of firms affected by what they believe their rivals might do interdependence of firms Goods could be homogenous or highly differentiated Branding and brand loyalty may be a potent source of competitive advantage Non-price competition may be prevalent Game theory can be used to explain some behaviour AC curve may be saucer shaped minimum efficient scale could occur over large range of output High barriers to entry
Oligopoly
Price
The kinked demand curve - an explanation for price stability? The firm therefore, charging demand IfThe principle of is effectively faces Assume the firm to lower its price to of the firm seeks the kinked a price a kinked demand on the principle rivals 5 andcompetitivean output of its to gain a curve rests curve forcing it producing advantage, 100. maintain asuit. Any gains pricing will will follow stable or rigid it makes that: If it chose to raise price above 5, its structure. Oligopolistic firms may in quickly be lost and the % change rivals would not follow suit andits firm a. If a firm raises its price, the overcome this by engaging in nondemand will be smaller than the % effectively facesnot follow suit rivals will an elastic demand price competition. total revenue reduction in price curve for its product (consumers would would If a firm lowers its price, its again fall as the firm now faces b. buy from the cheaper rivals). The % a relatively inelastic demand curve. rivals will all do the same change in demand would be greater than the % change in price and TR would fall.
Total Revenue B
D = elastic
Quantity
Duopoly
Collusion may be a possible feature Price leadership by the larger of the two firms may exist the smaller firm follows the price lead of the larger one Highly interdependent High barriers to entry Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market share and normal profit made In reality, local duopolies may exist
Monopoly
Pure monopoly where only one producer exists in the industry In reality, rarely exists always some form of substitute available! Monopoly exists, therefore, where one firm dominates the market Firms may be investigated for examples of monopoly power when market share exceeds 25% Use term monopoly power with care!
Monopoly
Monopoly power refers to cases where firms influence the market in some way through their behaviour determined by the degree of concentration in the industry
Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation encourages unwanted entrants to the market Sometimes seen as a case of market failure
Monopoly
Origins of monopoly:
Through growth of the firm Through amalgamation, merger or takeover Through acquiring patent or license Through legal means Royal charter, nationalisation, wholly owned plc
Monopoly
Price could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficient due to lack of competition (X- inefficiency) or
Monopoly
Innovation - could be high because of the promise of high profits, Possibly encourages high investment in research and development (R&D) Collusion possible to maintain monopoly power of key firms in industry High levels of branding, advertising and non-price competition
Monopoly
Often difficult to distinguish between a monopoly and an oligopoly both may exhibit behaviour that reflects monopoly power Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation Degree of contestability of the market may influence behaviour Monopolies not always bad may be desirable in some cases but may need strong regulation Monopolies do not have to be big could exist locally
Monopoly
Costs / Revenue
MC
7.00
AC
Monopoly Profit
3.00
This is curve for a monopolist Given both the short run and AR (D)the barriers to entry, likelyrunbe relativelyposition the monopolist will be able to long to equilibrium price inelastic. Output assumed the exploit abnormal profits in to for a monopoly be at profit entry to the long run as maximising output (note caution here market is restricted. not all monopolists may aim for profit maximisation!)
MR
Q1
AR
Output / Sales
Monopoly
Costs / Revenue
MC
7
MR
Q2 Q1
AR
Output / Sales
Monopoly
Costs / Revenue
MC
7
MR
Q2 Q1
AR
Output / Sales
Monopoly
Costs / Revenue
MC
7
AC
MR
Q2 Q1
AR
Output / Sales
Contestable Markets
Theory developed by William J. Baumol, John Panzar and Robert Willig (1982) Helped to fill important gaps in market structure theory Perfectly contestable market the pure form not common in reality but a benchmark to explain firms behaviours
Contestable Markets
Key characteristics:
Firms behaviour influenced by the threat of new entrants to the industry No barriers to entry or exit No sunk costs Firms may deliberately limit profits made to discourage new entrants entry limit pricing Firms may attempt to erect artificial barriers to entry e.g
Contestable Markets
Over capacity provides the opportunity to flood the market and drive down price in the event of a threat of entry Aggressive marketing and branding strategies to tighten up the market Potential for predatory or destroyer pricing Find ways of reducing costs and increasing efficiency to gain competitive advantage
Contestable Markets
Hit and Run tactics enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit) Cream-skimming identifying parts of the market that are high in value added and exploiting those markets
Contestable Markets
Examples of markets exhibiting contestability characteristics:
Financial services Airlines especially flights on domestic routes Computer industry ISPs, software, web development Energy supplies The postal service?
Final reminders:
Market Structures
Models can be used as a comparison they are not necessarily meant to BE reality! When looking at real world examples, focus on the behaviour of the firm in relation to what the model predicts would happen that gives the basis for analysis and evaluation of the real world situation. Regulation or the threat of regulation may well affect the way a firm behaves. Remember that these models are based on certain assumptions in the real world some of these assumptions may not be valid, this allows us to draw comparisons and contrasts. The way that governments deal with firms may be based on a general assumption that more competition is better than less!
Technology may prevent some firms from entering the market. Social forces such as bankers only lending to certain people may create barriers.
This requirement means that each firm's output is indistinguishable from any competitor's product.
The result is that the individual firm perceives the demand curve for its product as being perfectly horizontal.
Price $10 8 6 4 2 0
When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost
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The short run is a timeframe in which at least one of the resources used in production cannot be changed. Exit and entry are long-run phenomena. In the long run, all quantities of resources can be changed.
An Increase in Demand
An Increase in Demand
If input prices remain constant, the new equilibrium will be at the original price but with a higher output.
An Increase in Demand
The original firms return to their original output but since there are more firms in the market, the total market output increases.
An Increase in Demand
Price S1SR
Firm
MC AC
C SLR
$9 Profit 7
B A
700
8401,200 Quantity
1012 Quantity
Entry and exit occur whenever firms are earning more or less than normal profit (zero economic profit).
If firms are earning more than normal profit, other firms will have an incentive to enter the market. If firms are earning less than normal profit, firms in the industry will have an incentive to exit the market.
A zero economic profit is a normal accounting profit, or just normal profit. Firms produce where marginal cost equals price. No one could be made better off without making someone else worse off. Economists refer to this result as economic efficiency.
Lower labor costs mean Chinese firms can charge 30% to 50% less than their U.S. competitors for the same product. Makers of apparel, electric appliances, and plastics have been shutting U.S. factories for decades, resulting in the loss of 2.7 million manufacturing jobs since 2000. Meanwhile, America's deficit with China is likely to pass $150 billion this year.
Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made
The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero
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MC LRAT C SRATC
P = D = MR
14-75
Market
S0(SR)
Firm
MC
P1 P0
1
2 2
S1(SR)
ATC
S(LR) 1 D1 1 2 D0
P1 P0
SR Profits
1 1 2
Q0 Q1 Q2
Q0,2 Q1
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If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry If the long-run industry supply curve is downward
sloping, the market is a decreasing-cost industry
In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity
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Application: Kmart
Although Kmart was making losses, Kmart decided to keep 300 stores open because P>AVC
After 2 years of losses, Kmart realized that the decrease in demand was permanent
They moved from the short run to the long run and closed the stores because prices had fallen below their long-run average costs
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