Market Structure and Elasticity
This essay will show why each market structure has different levels of elasticity. First, it will focus on the definition of elasticity and then it will answer the question of the reasons for the differences in elasticity.
In economics, (price) elasticity is the level of responsiveness of supply or demand after the change of price (Mankiw, 2008). Hence, greater elasticity means higher quantity demanded or supplied goods or services after the price is decreased or increased respectively. In the majority of the cases, the researchers focus on the price elasticity of demand (Mankiw, 2008). Demand elasticity coefficient is calculated based on the percentage change in quantity demanded divided by percentage change in price (Mankiw, 2008; p. 91). Based on this elasticity coefficient, it can be suggested that price elasticity of demand might be perfectly inelastic (if it equal to 0), inelastic (if the coefficient is between 0 and 1) or elastic (if the coefficient is higher than 1) (Arnold, 2008; p.120). This can be exemplified by the following Diagrams 1-4 (SparkNotes, 2015). On Diagram 1 we can see that after the price has decreased by 25% the demand has increased by 200%, which indicates the price elasticity of 8 (elastic demand), while Diagram 2 represents the example of inelastic demand as increase of the price by 200% resulted in only 40% drop in demand; hence, the price elasticity is lower than 1.
Diagram 1 (left) and 2 (right)
Diagram 3 shows the example of perfectly inelastic demand, which is the hypothetical situation when the quantity demanded does not depend on the price while Diagram 4 shows the perfectly elastic demand, the situation when even the slightest change in price would eliminate all the demand (SparkNotes, 2015).
Diagram 3 (left) and 4 (right).
Pettinger (2014) says that petrol, salt, cigarettes can be regarded as the examples of price inelastic goods, while Porsche sports car or Tesco bread could be regarded as price elastic goods, mainly because of the numerous alternatives on the market. Hence, the elasticity is affected by the breadth of the definition of a good, as Tesco bread has a number of substitutes while bread itself has a lower number of substitutes with similar attributes (Mankiw, 2008). Other factors are the necessity of products, percentage of income spent on products, their duration and brand loyalty (ibid).
However, another crucial factor is the market structure (Pagoulatos and Sorensen, 1986; Arnold, 2008). There are generally four types of market structures: perfect competition, monopoly, monopolistic competition and oligopoly (Mankiw, 2008). In perfect competition, there are numerous producers of a single product without any differentiation, global agricultural production might be regarded as somewhat similar to perfect competition; however, this market structure used only as the hypothetical example (Gallant, 2015). As it can be seen on Diagram 5 (right), the equilibrium price of the market is determined by collective market demand and supply, however, as no individual firm can influence the price, we can be the perfectly elastic demand (Diagram 6), similarly to Diagram 4 (Boundless, 2016).
In the example of the monopoly market, there is only one producer of a unique good; this might be a particular medical treatment or government airways monopoly (Mankiw, 2008). This means, there are no alternative producers, which means lower elasticity. In the case there are no substitute products, this might be an example perfectly inelastic demand as demonstrated in Diagram 3. One possible example is the hypothetical situation when the government (or another seller) is the only producer of fresh water, and there are no alternatives to this product. Otherwise, there are always substitute products, for example, despite low elasticity of demand for bread among low-income households; the demand is not perfectly inelastic as there are substitute products (i.e. rice, potato, etc.). Hence, it is evident that monopoly leads to higher prices in most of the cases (Schwartzman, 1960).
In case there are different price elasticity of demand among different groups of consumers, barriers for reselling goods (i.e. it is service, such as haircut) and consumers lack any alternatives, monopoly maximizes own profit by offering different prices for different groups depending on their price elasticity of demand (Riley, 2016). In the hypothetical situation of perfect price discrimination, monopoly would the price that is equal to each buyer's willingness/readiness to pay, thus receiving maximum profit, given a particular marginal revenue (MR) marginal cost (MC) and average total cost (ATC), as shown on the Diagrams 7-8 (thisMatter, 2013).
However, this approach is often used on non-monopolistic markets, though the product offerings often differ in quality and attributes, the examples are air tickets or software prices depending on the category of users (Steen and Sørgard, 2002).
In the example of monopolistic competition, there are many producers, which mean higher competition; however, there is a product differentiation, which means the situation is different from perfect competition (Arnold, 2008). The elasticity of demand is evidently higher than in monopoly, given the availability of numerous substitute products; in most of the cases, it is higher than 1, (elastic demand as demonstrated in Diagram 1) (Blanchard and Kiyotaki, 1987).
Finally, the oligopoly market structure means there are few producers of slightly differentiated goods (Mankiw, 2008). The examples might be the market of global audit services and the Big Four, or global market of civil aircraft. As the products are similar and alternatives might be easily accessed, the demand is rather elastic in most of the cases often leading to price wars Fershtman and Pakes (2000). However, major market players might enter into a collusive agreement or even cartel to divide the market and fix the price to limit the competition on the market and ability for consumers to switch between products thus decreasing the elasticity of demand (Mankiw, 2008). However, there is a permanent threat the collision will fail and parties will enter the price wars.
This is exemplified in kinked-demand model, according to which the demand is elastic in case of price drop, as other players would decrease the price to prevent losing market share, while the increase in price might result in decrease of market share as competitors would not follow this step as Diagram 9 shows (Bhaskar, 1998).
References
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Bhaskar, V. (1988). The kinked demand curve: a game-theoretic approach. International Journal of Industrial Organization, 6(3), 373-384.
Blanchard, O. J., & Kiyotaki, N. (1987). Monopolistic competition and the effects of aggregate demand. The American Economic Review, 647-666.
Boundless, (2016). The Demand Curve in Perfect Competition, online, accessed on January 7 2016, available at: https://www.boundless.com/economics/textbooks/boundless-economics-textbook/competitive-markets-10/perfect-competition-66/the-demand-curve-in-perfect-competition-249-12346/
Fershtman, C., & Pakes, A. (2000). A dynamic oligopoly with collusion and price wars. The RAND Journal of Economics, 207-236.
Gallant C., (2015). Does perfect competition exist in the real world?, online, accessed on January 7 2016, available at: http://www.investopedia.com/ask/answers/05/perfectcompetition.asp
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Pagoulatos, E., & Sorensen, R. (1986). What determines the elasticity of industry demand?. International Journal of Industrial Organization, 4(3), 237-250.
Pettinger T., (2014). Examples of Elasticity, online, accessed on January 7 2016, available at: http://www.economicshelp.org/blog/7019/economics/examples-of-elasticity/
Riley G., (2016). Monopoly - Price Discrimination, online, accessed on January 7 2016, available at:http://www.tutor2u.net/economics/reference/monopoly-price-discrimination
Schwartzman, D. (1960). The burden of monopoly. The Journal of Political Economy, 627-630.
SparkNotes, (2015). What is Elasticity?, online, accessed on January 7 2016, available at:http://www.sparknotes.com/economics/micro/elasticity/section1.rhtml
Steen, F., & Sørgard, L. (2002). Price discrimination in the airline industry. Report submitted to the Nordic competition authorities, Norwegian School of Economics and Business Administration (NHH), Bergen.
thisMatter, (2013). Price Discrimination, online, accessed on January 7 2016, available at:http://thismatter.com/economics/price-discrimination.htm
