Market Structures

Market Structures

Market Structures Market structure refers to the competitive environment in which buyers and sellers of a product operate. Major Types- • Perfect competition • Monopoly • Monopolistic competition • Oligopoly

Perfect Competition • Large number of undifferentiated buyers and sellers • Each one is so small as to be insignificant to influence the market • The seller is a price-taker • Homogeneous products • No barriers to entry and exit- survival of the fittest

Perfect Competition • Well organised and continuous markets • Flexible market prices to keep responding to changing conditions of supply and demand • Perfect Knowledge on market condition, product and present and future prices, costs and economic opportunities- eliminates price differences

Perfect Competition • Perfect mobility of factors of production (raw materials, labour and capital)-this results in factor price equalisation. • No Government interference: No rationing, administered prices, subsidies etc.

Perfect Competition Presumption that free market operates in social interest- • “Invisible hand” and self-regulatory mechanism • Provides an effective check on the power of the sellers, safeguards consumer and makes it unnecessary for the State to intervene • Stock market is the closest example of a perfectly competitive market

Equilibrium Under Perfect Competition Note: Equilibrium is at the point of intersection between MC and MR MC cuts AC from below at its lowest point Firm may make profits, losses or break even in the short run- depends on its cost of production If firm makes abnormal profit, more firms will enter- Increase in supply- lower price and profit Opposite in case of losses

Firm Making Profit in Short Run P=AR=MR as represented by the horizontal line OP and OQ are equilibrium price and output. OPEQ represents Total Revenue OACQ is total cost. Here, TR>TC PECA is the short run supernormal profit. Y MC AC Cost/Revenue E AR=MR P A C O X Output Q Output

Firm Breaking Even in Short Run MC Firm breaks even where AC curve is tangent to AR. TR and TC are the same and given by rectangle OPEQ. There is neither loss, nor profit Cost/Revenue AC AR=MR P E O Q Output

Firm Making Loss in Short Run Total Revenue=OPEQ Total Cost=OBCQ Loss= BCEP MC AC C B P AR=MR E O O Q Output

Case of Exit or Shut Down Point • If prevailing market price is more than average variable cost (AVC) of production, the firm will continue production. • If prevailing market price is less than average variable cost (AVC) of production, the competitive firm will shut down production

Firm Making Loss in Short Run Total Revenue=OPEQ TVC= OKLQ TR < TC at price OP TFC= LKAB (Lost entirely) Operating Loss= OKLQ-OPEQ = PKLE At OP price, firm decides to shut down. MC SAC A B SAVC L K P AR=MR E O O Q Output

Perfect Competition Key lessons of perfect competition for managers • Important to enter the market as far ahead of the competitors as possible - when supply is low and price is high- this requires entrepreneurial skill • A firm earning an economic profit (as distinguished from normal profits) can not afford to be complacent because economic profit will attract new entrants • Only way for a firm to survive is to keep costs as low as possible

Perfect Competition • With growing globalisation, new competitive cost pressures are being felt by firms around the world • Indian companies have the advantage of low –cost labour but disadvantage of technology lag • (Obama on outsourcing)

Global Competitiveness Index Market Distortions • Efficiency of legal framework • Extent and effect of taxation • Number of procedures required to start a business • Time required to start a business

Global Competitiveness Index Competition Intensity of local competition Effectiveness of antitrust policy Imports Prevalence of trade barriers Foreign ownership restrictions

QUIZ • Elasticity of demand for a perfectly competitive firm is equal to _____. • Free entry and exit of firms is responsible for ________ _____ in the long run. • A perfectly competitive firm has all the following features EXCEPT: a) Price Taker b) Quantity adjuster C) Perfectly informed d) Price discriminator

Elasticity of demand for a perfectly competitive firm is equal to infinity • Free entry and exit of firms is responsible for normal profits in the long run • A perfectly competitive firm has all the following features EXCEPT: a) Price Taker b) Quantity adjuster C) Perfectly informed d) Price discriminator

QUIZ • In a perfectly competitive market, a firm in the long run operates at: A) AC=MC B) AR=MR C)MR=MC D) P=AR=MR=AC=MC

QUIZ TRUE OR FALSE? • The government sets the price of the product in a perfectly competitive market. • A perfectly competitive firm produces a substantial portion of the aggregate output. • There is no cost for entering a perfectly competitive market. • Factors of production can freely move in and out of the industry.

The government sets the price of the product in a perfectly competitive market.F • A perfectly competitive firm produces a substantial portion of the aggregate output. (F) • There is no cost for entering a perfectly competitive market. (T) • Factors of production can freely move in and out of the industry. (T)

Monopoly Features of Monopoly: • Single seller of a particular good or service • No difference between firm and industry • Large number of buyers • No close substitutes -cross elasticity of demand is zero • High entry barriers • Monopolist is a price setter/maker

Strength of a monopolist’s power depends on how much he can raise the price without losing all his customers- this depends on elasticity of demand, which in turn, depends on availability of substitutes • Before liberalisation, in India telephones, electricity, post& telegraph, oil &gas, railways were all monopolies.

Causes and Forms of Monopoly Barriers to entry- • Legal: Result of statutory regulation by government: Copy right, trade marks, government regulation, licence, tariffs and non-tariff barriers against import of goods • Technical; Technical know-how is available with only one person • Natural: Control over supply of raw materials or natural resources such as minerals, (De Beers produced 90% of entire world’s diamonds) • High costs of capital investment or economies of scale

Causes and Forms of Monopoly • Joint Monopoly: Through voluntary agreement, business companies jointly acquire monopoly power. e.g., Trusts, syndicates, cartels • Public Monopoly: Created for the welfare of the public- e.g., public utilities like water supply, electricity, railways, telephones • Private Monopoly: Owned an operated by private individuals or organisations- objective is profit maximisation

Causes and Forms of Monopoly • Simple Monopoly: Charges uniform or single price for a product to all the consumers- no discrimination between buyers or uses. • Discriminating Monopoly : Act of selling the same commodity produced under single control, at different prices to different buyers or different uses at the same time- not related to difference in cost of production

Regional Monopoly- • Geographical Indication under WTO creates a barrier for global competitors • Covers plants, seeds, herbs etc

Pricing& Output Decisions Under Monopoly Monopolist’s demand curve is downward sloping (AR=D). MR curve is below AR curve. Equilibrium tis MR=MC (at E) An ordinate drawn from E to X axis determines profit maximising output t OQ Given the demand curve AR, output OQ can be sold at a given time only at one price, ie., QL (= OP) Thus determination of outputsimultaneously determines the price. PLMK is the profit Y SMC SAC L P K M E AR= D MR O X Q

Monopolist’s Profit Whether a monopolist makes a supernormal or economic profit depends on: • Its cost and revenue conditions • Threat from potential competitors • Government policy. • If monopoly firm operates at MC=MR, its profit depends on the relative levels of AR and AC

Monopolist’s Profit • if AR>AC, there is economic profit • if AR= AC, there is normal profit • if AR<AC, theoretical possibility of the monopoly firm making losses

Measuring Monopoly Power • Number of firms criterion- Simplest- Fewer the number, higher the degree of monopoly power • Excess Profit Criterion- here, opportunity cost of the owner’s capital and a margin for risk are deducted from the actual profit made by the firm. • Triffin’s cross elasticity criterion - lower the cross elasticity of the product of the firm, greater the monopoly power.

Measuring Monopoly Power • Concentration ratioof an industry is used as an indicator of monopoly power - relative size of firms in relation to the industry as a whole. • Cn is the percentage of market output generated by the n largest firms in the industry • Herfindahl- Hirschman Index(HHI) is a measure of the amount of competition in an industry

Herfindahl- Hirschman Index (HHI) • Measure of the size of firms in relation to the industry • Indicator of the amount of competition among them. • An economic concept widely applied in competition law and antitrustlaws.

Measuring Monopoly Power • The index involves taking the market share of the respective market competitors, squaring it, and adding them together.

Herfindahl- Hirschman Index(HHI) • It can range from 0 to 10,000, moving from a huge number of very small firms to a single monopolistic producer. Interpretation of H- index: • Below 0.10 (or <1,000): No concentration • Between 0.10 to 0.18 (or 1,000 to 1,800): Moderate concentration. • Above 0.18 (> 1,800) : High concentration • .

The United States uses the Herfindahl index to determine whether mergers are equitable to society; • The Antitrust Division of the Department of Justice considers Herfindahl indices as discussed above. • As the market concentration increases, competition and efficiency decrease and the chances of collusion and monopoly increase.

Measuring Monopoly Power • While the threshold is considered to be "0.18" in the US, the EU prefers to focus on the level of change. • Increases in the HHI generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite.

In Europe, concern is raised if there's a "0.025" change when the index already shows a concentration of "0.1". • E.g., if in a market , company B (with 10% market share) suddenly bought out the shares of company C (which also has 10%) then if this new market concentration makes the index jump to "0.172". • This would not be relevant for merger law in the U.S. (being under 0.18) but would in the EU (because there's a change of over 0.025)

Monopoly Power The usefulness of this statistic to detect and stop harmful monopolies is directly dependent on a proper definition of a particular market E,g., If we were to look at a hypothetical financial services industry as a whole, and found that it contained 6 main firms with 15 % market share each, then the industry would look non-monopolistic….

Monopoly Power But suppose that one of those firms handles 90 % of the savings accounts and physical branches (and overcharges for them because of its monopoly), and the others primarily do commercial banking and investments. • In this scenario, people would be suffering due to a market dominance by one firm; the market is not properly definedbecause savings accounts are not substitutable with commercial and investment banking.

Monopoly Power • The problems of defining a market work the other way as well. • For example, one cinema may have 90% of the movie market, but if movie theatres compete against video stores, pubs and nightclubs, then people are less likely to be suffering due to market dominance of the cinema.

Monopoly Power • Another typical problem in defining the market is choosing a geographic scope. • For example, 5 firms may have 20% market share each, but may occupy five areas of the countryin which they are monopoly providers and thus do not compete against each other. • A service provider or manufacturer in one city is not easily substitutable with a service provider or manufacturer in another city

Case of New York City Taxi Industry Market Value of Monopoly Profits • Like most US cities, New York city requires a medallion (license) to operate a taxi. • Medallions are limited in number and this confers monopoly power to owners. • Value of owning a medallion is equal to the present discounted value of the future stream of earnings from the ownership of a medallion.

Market Value of Monopoly Profits in New York City Taxi Industry • No of medallions in New York city remained at 11,787 from 1937 to 1996 when it was increased by only 400 to 12,187. Value of medallion rose from $10 to $250000 by 1999 or 18% per year. • Proposals to increase the number of medallions was blocked by the taxi industry lobby. If licenses to operate were freely granted, then the price of medallions would drop to zero.

Market Value of Monopoly Profits in New York City Taxi Industry • Instead of doing that, New York city allowed a sharp growth in the number of radio cabs, which can respond only to radio calls and can’t cruise the streets for passengers. • This sharply increased the competition in NY taxi industry and reduced profits to the taxi owners from 33% in 1993 to 11% in 1999 - from Wall Street Journal quoted in Salvatore

Discriminating Monopoly/ Price Discrimination 3 forms: • 1st Degree: Different rate for every unit of output- discrimination between buyers / between units • Monopolist forces every consumer to part with his entire consumer surplus-Full benefit of trade goes to trader. (Auction is one example, but it is for special products)

2nd degree Discrimination • 2nd Degree: Buyers are divided into different blocks or groups and then different rates charged for each block or group: • Here, consumers enjoy a part of the consumer surplus and monopolist is also able to get a part of the surplus; E.g., electricity charges, Quantity discounts

3rd degree Discrimination • 3rd degree: Most common type-Seller divides his buyers into sub-markets and charges a different price for each market- • Dumping is an example: High price in domestic market and low in international market. • Reasons: To dispose off surplus; to remove rivals; to take advantage of increasing returns to scale; to create new demand abroad. • As demand is elastic in international market, he has to reduce price but charges a higher price in the domestic market as domestic demand is inelastic

When is Price Discrimination Possible? Conditions of Price Discrimination ( When is Price discrimination possible?) • Consumers are unaware of the difference in prices charged • Price difference so small that consumers don’t bother • Price illusion/ irrationality • Markets are situated far from one another and so it is expensive to transfer goods from one market to another (Geographical distance)

Conditions of Price Discrimination • When elasticities of demand in the two markets are different: higher price for low elasticity market and lower price for high elasticity market. • Direct personal services such as those of doctors and lawyers where resale is not possible • Legal sanction provided by government: e.g., lower prices in army canteen

Market Structures