Market Structures – Market Classification

Market Structures – Market Classification

Market Structure refers to the characteristics of a market that influence the behavior and performance of firms and describes the competition environment in the market for any goods or services. Market Structures describe the important features of a market, such as the number of suppliers, the product’s degree of uniformity, the ease of entry into the market and the forms of competition among firms. Based on the type of competition, markets are classified as perfectly competitive and imperfectly competitive.

Perfect Competition: Refers to market structure where competition among the sellers and buyers prevails in its most perfect form. Depending of the demand and supply of service or commodity, a single price exists for the particular commodity in a perfectly competitive market.

Examples: Most agricultural products such as wheat, corn, and livestock; markets for basic commodities such as gold, silver, and copper; markets for foreign exchange and widely traded stock.

Features of Perfect Competition:

      Large number of buyers and sellers

      Homogeneous product

      Freedom to enter and exit

      Perfect knowledge

      No existence of transport costs

      Perfect mobility of factors of production

      Each firm a price taker

Demand Curve for firm: Horizontal and elastic

Price = Average Revenue = Marginal Revenue

Short Run Profit Maximization or Minimizing short-run losses: The firm maximizes economic profit by finding the quantity at which the total revenue exceeds total cost by the greatest amount. To maximize profit or minimize loss, a firm should produce the quantity at which marginal revenue equals marginal cost; provided marginal cost cuts marginal revenue from below.

Perfect Competition in the Long Run:

Ø  Short-run economic profit attracts new entrants in the long run and may cause existing firms to expand. Market supply thereby increases, driving down the market price until economic profit disappears.

Ø  A short-run loss, in the long run, forces some firms to leave the industry or to reduce their scale of operation. In the long-run, departures and reductions in scale shift the market supply curve to left, thereby increasing the market price until remaining firms break even – that is earn, a normal profit.

Ø  Perfect competition guarantees both productive efficiency and allocative efficiency in the long run. 

Imperfect Competition: When the conditions of perfect competition do not exist in a given market, it is said to imperfect market. Based on the number of buyers and sellers, the imperfect markets are classified as follows:

•  Monopoly
• Monopolistic Competition
• Duopoly
• Oligopoly
• Monopsony 
• Duopsony
• Oligospony

Monopoly: Monopoly is the sole supplier of a product with no close substitutes.

Examples: Patented Products, Some prescription drugs, Postage Stamps

Features of Monopoly:

      Single person or a firm

      Large number of buyers

      No close substitutes

      Price Maker

      Entry Barriers

Demand Curve for a firm: Downward sloping Curve and Inelastic

Price: Marginal Revenue<Average Revenue

  

Short Run Profit Maximization or Minimizing short-run losses

• The monopolist chooses either the price or the quantity, but choosing one determines the other- they come in pairs.
• The profit maximizing firm produces where total revenue exceeds total cost by the greatest amount.
• If the price covers the average variable cost, the monopolist produces, at least in the short run, or else shuts down.

Long Run Profit Maximization: If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist into the long run.

Monopolistic competition: When there are many firms and each one produces such goods and services that are close substitutes to each other but not identical.

Examples: Convenience stores

Features of Monopolistic competition:

      Existence of many firms

      Product differentiation

      Free entry and exit of firms

      Selling costs-high

      Imperfect knowledge

Short Run Profit Maximization or Minimizing short-run losses:

•  The monopolist chooses either the price or the quantity, but choosing one determines the other- they come in pairs.
• The profit maximizing firm produces where total revenue exceeds total cost by the greatest amount
• If the price covers the average variable cost, the monopolist produces, at least in the short run, or else shuts down.

Long Run Profit Maximization

Monopolistically competitive firms earn zero economic profit in the long run because market entry is easy.

Oligopoly: A market structure characterized by so few firms that each behaves interdependently

Examples: Industries such as automobiles, oil, breakfast cereals, personal computers, etc 

Varieties of Oligopoly:

• Undifferentiated Oligopoly: Sells product that does not differ across suppliers
• Differentiated Oligopoly: Sells product that differ across suppliers

Features of Oligopoly:  

     Existence of only few firms

     Product differentiation

     Interdependence among firms

     High advertising and selling costs

    Each firm knows that any changes in its product’s quality, price, output, or advertising policy may prompt a reaction from its rivals.

     Some forms of barriers to entry such as economies of scale, legal restrictions, brand names built up by years of advertising, or control over an essential resource exist.

Models of Oligopoly:

Based on the diversity of observed behavior, Oligopoly can be collusive or non-collusive.

1) Collusive Oligopoly: It is a way of reducing the uncertainty associated with oligopolistic interdependence. There are two main types of collusive agreements.

• Price leadership or tacit collusion: This occurs when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes driven by the dominant firm.
• Cartels or overt collusion: This occurs when firms openly agree on price, output and other decisions aimed at achieving monopoly profits. A group of independent producers working in unison is called a cartel. This can be formed either based on sharing the market or maximizing profit jointly by non-price competition.

2)  Non-collusive Oligopoly: Firms assume that there will be a certain reaction from their competitors for any action taken by them.

• Cournot Model – Augustin Cournot (1838): Each firm assumes that the other keeps the output constant. A reaction curve gives the relationship between how a duopolist reacts to the other duopolist’s action.
• Kinked Demand Curve Model or Price Rigidity Model – Paul Sweezy (1939): An oligopoly firm believes that if it reduces the price, the other firms will follow suit by matching the price cuts but if it increases the price, other firms will not follow. This led to a kink in the demand curve, which occurs in the existing price. In this model, oligopolists recognize their interdependence but act without collusion in keeping their price constant. Thus the oligopolists prefer to compete with others on the basis of non-price competition policies rather than price policies.