Abstract
Market structure refers to the interaction between various buyers and sellers. Different market structures have different characteristics. The characteristics of the market structure determine the realized outcomes. There are three main market structure: perfect competition, oligopoly, and monopoly. Perfect competition has many sellers. Therefore, they do not have any market power. They cannot influence market outcomes. An oligopoly has few firms with some market power. They can influence the outcomes. Monopoly comprises of only one firm with absolute market power. Therefore, it can influence the realized outcomes. This paper highlights the characteristics of the various market structures. It then evaluates the realized outcomes. Real world examples of each market are provided. However, real world examples may be difficult in many instances. This is because most markets are hybrids of various market structures. It is difficult to find an exact market with the characteristics that are discussed in theory in economics.
Perfect Competition
Perfect competition market is hardly to be achieved in real life but this model is widely applied in analyzing some industries with features nearly similar to perfect competition.
Assumptions of perfect competition market:
There are many suppliers and consumers in the market.
Firms are price takers. First are too small that they have no influence on market price. In general, firms take price as given and provide an amount that can generate the highest profit.
All firms produce homogeneous goods and customers have homogenous preferences. In other word, consumers are indifferent between goods produced by different companies.
Both sellers and buyers have perfect competition about the market. It implies that both sellers and buyers are well-informed about the price and quantity of other producers.
There is no entry or exit barrier. It means firms are free to enter or exit the market. Firms currently operating in the market can decide to quit it and those who find the market profitably attractive can enter the market. Existing firms can re-enter the market again without any constraint.
There are several additional assumptions such as perfect factor mobility, no transaction cost, no increasing return to scale and no external effects .
Characteristics of perfect competitive market:
Price equals to marginal cost (P=MC)
Price equals to average cost (P=AC)
Therefore, P=AC=MC. In this market, there is no possibility to improve social welfare and no firm makes positive economic profit and there is no possibility to improve social welfare. However, zero economic profit does not mean no accounting profit. In this case, firms get accounting profit equal to opportunity cost. Opportunity cost is estimated as the value of the best alternative available to a firm. Hence, firms are indifferent between staying and leaving the market.
Since firms are price-takers, the individual firm’s demand curve is a horizontal line at the market clearing price. Marginal revenue (MR) is defined as the additional revenue being generated by selling an additional unit of goods. Due to a constant market price, the additional increase in revenue is equal to the price. Hence P=MR=MC
Profit-maximizing output
Short run analysis
In the short run, firms are constrained by fixed amount of resources so they maximize profit by changing output. If firms should produce if the total revenue is larger than total production cost or if the profit loss is smaller than fixed cost. In case the loss is more than the amount of fixed cost, firms should stop their production to minimize the loss. Continuing the production makes firms even worse off. Therefore, the operation point of firm in the short run is P=AVC.
Comparison between MR and MC: if MR>MC, firms should increase output because the marginal profit of producing additional unit is higher than the marginal cost of that unit. If MR<MC, firms should reduce their output. In case MR=MC, firms should keep their production constant. Producing additional unit leads to MR<MC due to decreasing return to scale.
Long run analysis
In the long run, if there is positive profit, firms enter the market and provide more goods. Due to an increase of output, the price reduces until there is no profit for all firms. In case of negative profit, some firms exit the market. A reduction of output leads to an increase in price until all firms get zero profit. At this point, the provision of goods remains stable. Therefore, in the long run, the market equilibrium is generated at which P=MC=AC=MR.
Efficiency analysis
Perfect competitive market leads to both allocative and productive efficiency
Allocative efficiency (P=MC)
It is understood as the state at which the valuation of customer of a unit is equal to the production cost of producing that unit. In case of perfect competition, consumer plus and producer surplus are maximized. There is no way to enhance social welfare. This is also the case of Pareto optimal allocation at which no one can be better off without making others worse off.
Productive efficiency (P=AC)
Productive efficiency or cost efficiency occurs when goods are produced at the lowest possible cost. It can be obtainable in perfect competitive market because firms with higher production cost make profit loss and are forced to leave the market.
Relevant economic theory of perfect competition market
In perfect competitive market, consumers have the highest consumer surplus because they can easily shop at any place with the homogenous price . On the contrary, producers get zero producer surplus since consumers can easily replace their products by other substitutes. Overall, the social welfare and consumer surplus are maximized. There are different arguments about the effectiveness of perfect competitive market. Neoclassical theory claims that perfect competitive market generates the best outcome for both society and consumers. In addition, it is the strong competition among firms that forces them to make an improvement in their competitive position as compared to their competitors. The others claim that in the age of innovation and development, a purely perfect competition market is not a good model for market structure. Firms have no incentive to invest into innovation if they cannot affect price or customers are identical to goods produced by various sellers. There is a lack of incentive to invest into R&D activities. Moreover, perfect information dissuades firms from developing advanced technology due to the possibility of information sharing. However, producers’ motivation to innovate is determined not only by the presence of competition but also by the profitability extracted from their investments .
Examples of perfect competition market
Many conditions are required to make a market perfect competition; therefore, in reality the pure perfect competition hardly exists. In other word, purely perfect competition is more theoretical than practical. However, there are thousands of markets in the world with properties close to perfect competition. A typical example is bakery market. At this market, many sellers sell the same type of bread and many consumers try to buy it. Furthermore, market participants make rational decisions. Bread sellers seek for profit maximization while consumers’ goal is to optimize their utility. Buyers have the same preference of bread for every bakery shop. Sellers and buyers also have good knowledge of the good and its market price. Customers are indifferent between bread sold by different bakery shops so they can easily buy the goods at any shop. There is very little constraint about entering and leaving the bakery market.
The bakery market can be represented in the diagram below:
Figure 1: Perfect competition market
Since there are so many bakery shops in the market, bread sellers are price-takers. They sell bread at market clearing price at which P=MC=MR. The demand curve is horizontal or it has perfect elasticity price of demand. At the market price P, the quantity demand and supply is Q. At this quantity, all bakery shops have zero economic profit. It means they are indifferent between selling bread and doing a best alternative option. At P=ATC, sellers make a profit loss which is equal to fixed cost C. At this point, bakery shops should be close in order to minimize the loss. In this case, the shop owners just only lose the fixed cost such as rent of the shop and insurance.
Monopoly market
In contrast to a perfect competitive market in which there are many suppliers, a monopoly is a market structure in which only one firm provides a product. There are different types of monopoly market. If the product does not have any close substitutes, the market become pure or natural monopoly. Some examples of pure monopoly are electric power and natural gas. If the product has a remote substitute, the market becomes imperfect monopoly . To some degree, there is a fear of potential competition. An example of imperfect monopoly is mobile telecom industry. A potential competitor of mobile industry is fixed landline phone industry. However, this paper studies natural monopoly which potentially causes market failure.
Natural monopoly exists when the largest producer in an industry has a huge cost advantage in producing the goods than any other actual and potential rivals, resulting in economies of scales when the firm produces a higher volume. It means it is cheaper for one firm to produce the whole amount of products than many firms produce the good together .
Assumptions of natural monopoly market:
There is a sole firm in the market. The firm is price setter.
There is no substitute for the product.
There is extremely high barrier to entry and exit the market
The firm is profit maximizer in both short run and long run
Economies of scale: CQ<Cq1+Cq2++C(qn) with Q=q1+q2++qn
There are several reasons of economies of scale: the first one is fixed cost digression which has a form: Cx=vc*x+Fc. Average cost decreases when a firm increases production. The other reason is learning effect. Since monopoly is often established for a long period of time, it can learn from its experience and overtime it can produce the same goods at a lower cost. Other explanations may be two-third rule, principle of the least common multiples.
Efficiency analysis:
Allocative inefficiency (P>MC): natural monopoly leads to allocative inefficient because quantity is lower than market demand. The monopoly provides small amount of goods in order to control price. Price is higher than the production cost of an additional unit. For this reason, expanding production could increase social welfare.
Cost efficiency: natural monopoly does not necessarily lead to productive inefficient. If some assumptions in perfect competitive market is violated, natural monopoly is more cost efficient than perfect competition, especially in case of subadditivity or fixed cost digression. If the average cost declines continuously, setting price equal to marginal cost can lead to profit loss .
Social welfare: natural monopoly leads to deadweight loss. The reason is that market power enables the monopolist to set price above marginal cost. The firm tries to extract consumer surplus as much as possible. Firms get positive economic profit. Compared to perfect competition, the supplier has positive producer surplus but consumers lose consumer surplus. In total, social welfare decreases seriously and there is considerable deadweight loss .
An example of monopoly:
Deutsche bahn is a monopoly company in railway market in Germany. In order to build rail track, a company needs to invest in a huge network of rail track throughout the country. However, because Deutsche bahn can transport millions of people, the fixed setup costs are distributed among large amount of transporters. Moreover, an additional customer can help to reduce the average cost of production. Or average cost decreases overtime when more people use the product. The extremely high market entry prevents other firms to enter the train market, thus making Deutsche bahn the only provider of train means of transportation. For this reason, Deutsche bahn can set very price above marginal cost and increase its profit. In the figure below, we can see that Deutsche bahn has a decreasing average cost when it expands the production and the MC is always below AC. If Deutsche bahn behaves as in perfect competitive market by setting Pc=MC and providing Qc=Q it suffers from profit loss. In this case, Deutsche bahn sets price at Pm at which MR=MC and Qm=Q. At this price, the firm gets the maximize profit and customer surplus decreases. Overall, welfare is smaller in case of perfect competition due to higher price and lower quantity. If the government restricts Deutsche bahn to produce at Pcr=MC at which Qm=Q, there is a considerable improvement in welfare.
Figure 2: Monopoly market structure
Comparison between perfect competition and monopoly:
Advantages of monopoly: market power allows firm to set higher price than in case of perfect competition. Therefore, firms can earn a large amount of profit which may be invested in R&D activities. It is well-known that R&D activities require a lot of investment and they are very risky and uncertain. In reality, we observe that most of R&D activities are conducted by large firms because they have more financial power and advantage. Importantly, a monopoly can avoid imitation since a powerful firm can hinder powerless firms from copying its goods. The monopoly firm often has a well-functioning legal framework which aims to prevent imitation . Another good point of monopoly market structure is that it is more efficient and convenient. For instance, allowing one firm to provide natural gas in a region is more convenient for people involved. Furthermore, a monopoly is often a big company which have a strong network effect and provide many jobs and a good working environment.
Disadvantages of a monopoly market structure in comparison with perfect competitive market:
Overall, the drawbacks of monopoly outweigh its benefit. In general, monopoly often benefits itself only and consumers suffer from it. Consumers have no option to substitute the product. Additionally, the absence of competition may decrease the motivation to innovative or improve the product quality. Moreover, a monopoly often takes advantage of market power by establishing very high price without any improvement of quality and efficiency. Therefore, monopoly is considered illegal in many countries such as USA.
Several policy implications for two types of market structure
It is no doubt that policies always encourage competition. Competition helps to improve quality and encourage firms to invest into cost efficiency methods. In particular, competition benefits from international competitors and consumers. For example, European Commission always try to motivate competition in order to make the market function well. Monopoly in many cases is considered as a main reason for market failure. To protect customers and reduce welfare loss, governments try to regulate the monopoly by several ways. A feasible policy is price regulation. The monopoly is required to set price equal to marginal cost. In this case, the monopoly suffers from profit loss. To solve this problem, the government will compensate the loss for the monopoly. The advantage of this policy is that it leads to allocative efficiency. However, it is very hard to measure marginal cost in reality and at the end, the government has to raise tax which burdens the whole society. Another policy is to set price equal average cost. The advantage is that it is easier to measure average cost than marginal cost. The natural monopoly does not have profit loss so there is no need to increase tax. However, the issue is that price is still higher than marginal cost and there is some deadweight loss. Even though it is not fully efficient, in comparison with the first policy, it has fewer problems. The common policy is auction the monopoly position. The biggest advantage is that the most efficient bidder is the winner. Additionally, the government can obtain a huge fraction of monopoly profit through monopoly rent and reinvest it in other activities. The issue is that the monopoly may provide goods with low quality and increase price. Therefore, it is very important for the government has to control the quality of product provided by the monopoly.
Overall, the characteristics of two mentioned above market structures can be summarized as follows:
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