Types of competitive markets
A perfectly competitive market structure is a hypothetical market
structure in which there are many firms, each with a small market
share, that all sell an identical product.
There is perfect information available to firms and consumers about
prices and quality of goods.
Firms can freely enter and exit the market.
Identical products/Homogeneity of products.
Many small firms
The Firms take the price set by the entire market and they do not have
enough market power to influence it.
Even though this is a hypothetical market structure, there are some
industries that come close. Commodities are types of goods, usually
primary goods and natural resources, for which it does not matter who
produces them.
Commodities have full or partial fungibility. This means they are
perfectly interchangeable with goods from other producers.
Examples include coal, crude oil, corn, soybeans, milk and sugar.
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Monopoly
A monopoly is when just a single firm is operating in the entire market.
It is the result of strong barriers to entry and exit.
Assumptions
Only one firm
No close substitute
Barriers to entry
Barriers can include:
the firm enjoying economies of scale, with new firms struggling
to compete due to large start-up costs
very brand loyal, creating problems for any potential new
entrants.
Monopoly firms can exhibit predatory behavior eg reducing the
price.
Legal protections created by the government, such as patents.
Natural monopoly is where there are large infrastructure
investments required, such as rail and communication networks.
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Monopolistic competition
Monopolistic competition is the most competitive and the most
common market structure.
There are many firms in this market structure, each with a relatively
small size compared to the size of the market.
They sell similar goods, but the goods are not identical (differentiated
goods)
Branding is what commonly sets firms apart from each other.
Each firm has some market power but not a significant amount.
They will rely heavily on advertising their brand to attract consumers.
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Market Structure
Number and Size of Firms
Competition
Market Power
Exampe
Perfect Competition
Many small firms
Perfect
None
Milk
Monopoly
One large firm
None
All
Microsoft
Monopolistic Competition
Many small firms
Strong
Limited
Clothing
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Rational producer behaviour
All firms practice profit maximisation, then we know that this
motivation is central to market efficiency.
When firms act as profit maximisers, we say that they are behaving
rationally – they have studied their costs and acted in a way that will
minimise those and make the most profit for their owners.
Economic costs are defined as the sum of implicit and explicit costs,
with implicit costs being the opportunity cost of the business decision
and explicit costs being the costs of production itself.
A person in business is only concerned with covering the business
costs, but economists are also interested in whether the decisions made
within the business were the right ones, and so we must consider
economic costs.
If a firm only covers its economic costs, the firm is said to be making
a normal profit.
Once a firm surpasses this level, it is said to be making
an economic or abnormal profit.
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Costs of production
The costs of production can be broken down in terms of total, average
and marginal costs.
In the short term, there will be some fixed costs that do not change.
Fixed costs are the costs that do not vary when output changes. An
example of a fixed cost is rent.
Variable costs are those costs that do vary when output changes. An
example of a variable cost is the materials and components for
production.
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The cost values for a firm exhibit diminishing marginal returns once
productivity per worker begins to slow down and costs begin to rise.
This concept describes the relationship between inputs and outputs, as a
firm employs more variable units of inputs in the short run (At least one
factor of production is fixed).
Wages need to be paid per worker, and as we employ more labour, the
relative gains in output will decrease.
This is because, after a certain point, each time an additional worker is
added, it will increase output by a smaller and smaller amount.
There may even be a point at which each additional worker decreases
overall output.
This will mean that the marginal cost will start to increase relative to
the increase in output.
At some point the cost per worker, or average cost, will also begin to
rise.
Economists often say that the marginal pulls the average up or down.
For example, if a fishing boat catches another tuna fish which is large,
the average weight of all caught tuna will go up. If the tuna fish was
small, then the average weight of the entire catch would go down.
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Profit maximisation
Maximum profits mean that the owners or shareholders get the most
back on their original investment.
Advantages of maximizing the profit
Entrepreneurs are rewarded with profits.
Firms can use these profits to fund research and development,
thereby securing a place in the market.
Maximising profits is a very clear goal for employees and
managers, which allows targets to be set, and wages can be tied
to profits as an extra incentive.
The difference between the total revenue and the total cost will give us
the profit for the firm.
The marginal revenue and marginal cost are the gradients for total
revenue and total cost respectively.
In other words, they are the rates of change of total revenue and total
cost hence profit is maximized where they intersect is MC=MR.
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The productively efficient point for any firm will be when it is
operating at lowest average cost ie when the marginal cost and average
cost curves intersect.
Allocative efficiency
This is the point at which the market allocates resources at the socially
optimal level of output.
This occurs when supply equals demand or marginal social
benefit equals marginal social cost.
At Figure 3, we can see that in the short run equilibrium at P 1 and Q 1 ,
marginal cost intersects the demand curve, making the firm allocatively
efficient.
Evaluation of perfectly competitive markets
In the short run, firms are able to earn abnormal profits, while being
allocatively efficient.
Prices and output will be lower than in other market structures and in
the long run firms will be productively efficient.
There are some situations where the product is very similar (for
example, the market for crude oil), but there are still slight differences
in the product and in the way that it is sold.
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A monopoly doesnt need to be productively efficient, because it will
make more profit at the profit-maximising level of output.
There is no threat from competition to force it to try to minimise costs.
Allocative efficiency
A monopoly doesn't need to be allocatively efficient and there is no
threat from competition to force it to allocate resources better.
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Evaluation of monopolies
When monopolies are compared to a perfectly competitive firm, the
monopolist charges a higher price (P M compared to P C in Figure 8), sells
a reduced quantity to the market (Q M compared to Q C ) and is not
efficient in any way.
This diagram shows the resulting consumer and producer surplus,
compared to a perfectly competitive market.
Producer surplus increases from the area under P C and above MC to the
entire purple shaded area. Consumer surplus decreases from the area
above P C and below D to just the green shaded area.
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Natural monopolies
Another instance in which we may want to have just one firm operating
in a market is called a natural monopoly.
Some industries operate over a much broader range of output, for
example a utilities firm, and it can make sense for a single company to
operate.
In the case of utilities, the firm needs to have a massive infrastructure
in place in order to provide the good or service.
