ECON2/5: MARKET STRUCTURES-S.5

This unit talks about Market Structures and how they work.

In the today usage a market refers to a place where commodities are bought and sold. In economics, a market is any arrangement through which buyers and sellers come into contact to carry out transactions.

There are different types of markets e.g.

i.Commodity markets (where gods and services are traded).

ii.Factor markets (where factors of production are traded).

iii.Spot markets (where a commodity is traded for immediate delivery)

iv.Future markets (where contracts for delivery at a future date are made).

v.Controlled markets (where there is government influence in form o fixing prices.)

Market structures on the other hand and refers to the characteristics of a particular market organization which affect the efficiency in output of a firm.

Market structures can be classified as;

a.Perfect markets (e.g. perfect competition, perfect oligopoly)

b.Imperfect markets (e.g. monopolist competition, monopoly, imperfect oligopoly)

There are four major forms of market structures i.e. perfect competition, monopolistic competition, monopoly and oligopoly.

PERFECT COMPETITION

This is a market structure where there are many sellers and buyers of a homogenous product.

It is an ideal market situation which however does not exist in the real world situation.

Characteristics of perfect competition

  • There are many sellers in the industry each producing a small proportion of the industry’s total output therefore no firm or seller can influence the price of the product in the market by changing its output because its contribution to total output is small.
  • Firms in the industry sell a homogenous product which is identified in all ways to the products of its competitors therefore consumers are not expected to prefer the product of one firm to the product of the other firms in the industry.
  • All firms in the industry charge the same price for the product. Each firm is free to put as much output as it wishes on the market at the ruling market price.

A firm under perfect competition is therefore a price taken and not a price maker because it cannot determine the price at which to sell its products. The price is determined by total supply and demand of the industry

Market structures

Market structures 1

  • A firm under perfect quality has a perfectly elastic demand curve implying that whatever output produced by the firm has to be sold at that price which is determined by total supply and demand of the industry.

Market structures 2

  • There is free entry and exit.

Firms have freedom f movement in and out of the industry. Any firm with capital is free to enter the industry and start producing of commodity. For a firm that wishes to leave the industry, it is also free.

  • It is assumed that there are no transport costs.

No firm incurs any extra cost by buying from a different source of raw materials and no buyer incurs any cost buying by buying from different seller therefore the producers, the buyer, raw materials are all in the same location.

  • There is no advertising because all firms produce homogenous products.
  • The goal of all the firms is profit maximization and this is at a point where.
  • Perfect mobility of factors of production.

Factors of production can move freely from low paid economic activities to highly paid ones.

  • Perfect knowledge.

Consumers and sellers have complete knowledge about market conditions and the price at which the products are bought and sold.

This implies that all the firms have to charge the same price since if one if one firm charges a higher price, it won’t make any sales because the consumers are aware of the prices charged elsewhere had that the commodities are homogenous.

N.B:

The first 10 characteristics or features of pure competition and all the 12 features are features of perfect competition.


A demand curve of a firm under perfect competition.

The demand curve of a firm is indicated by the average curve under conditions of perfect competition, all units of output are sold at the same price because the firms are price takers. A firm’s cannot raise its price because its sales will fall to zero as customers will switch to other firms in the industry.

Alternatively,  the firm cannot lower the price because it will be forced to rise it gain therefore the demand curve is perfectly elastic because the firm produces a small portion of the total output of the industry which  can not affect the price of the commodity. In perfect competition, the extra unit of output has to be sold at the prevailing price and this leads to a situation where;-

Market structures 3

If a firm produces output OQ, it will sell at price OP and still where it increases output OQ, it will sell at the same price OP.

Supply curve of a firm under perfect competition

The supply curve of a firm is indicated by the marginal cost curve. Under perfect competition, and all the rest of the market structures, the supply curve of a firm is indicated by the portion of the marginal cost curve i.e. above the average cost curves lowest point

Market structures 4

The supply curve is indicated by portion AB

The industrial supply curve can be derived from the horizontal summation of all the individual supply curves of the industry.

Market structures 5

Market structures 6

Out put determination under perfect competition

Any firm under perfect competition is expected to aim at profit maximisation and every firm will produce that level of output where MC = MR ie where the amount of money got from selling an extra unit of ouput is equal to the cost incurred in producing that extra unit of output

If the amount of money got from selling an extra unit of output is greater than the cost incurred in rpoducing that extra unit output (MR MC)

Then at that level of output, the firm will be losing some profits and it pays for the firm to produce more and increase output to enable where MC = MR.

If the amount of money got from selling an extra unit of output is less than the cost incurred in producing that extra unit of output (MC MC) then the firm will be incurring losses by producing more output and it pays for the firm to reduce output to a point where MC= MR.

average revenue

If the firm produces output OQ, MR > MC, it pays for the firm to increase output. If the firm produces output OQ2 where MR< MC, it pays for the firm to produce output to a level of output OQ0 where MC= MR.

N.B.:

The firm cannot produce the level of output at point B although MC= MR at that point simply because at that point as output of the firm increases, MC reduces implying that the firm will be losing some profits at that level of output and it will benefit more by increasing output.

Short run equilibrium position of a firm under perfect competition

Under perfect competition of a firm equilibrium when it is of no advantage to increase or decrease its level of output or change its method of production by charging the proportion in which the factors of production are combined.

The condition for equilibrium (profit maximization) is where MC = MR and the graph at the equilibrium point, the MC curve    cuts the MR curve from below.

In the short run a firm in equilibrium can make economic profits (abnormal profits). This is the level of profits over and above the normal profits. They attract new firms in the industry. A firm will make abnormal profits if at equilibrium level output AR (PT >AC)

abnormal profits

Shaded area = abnormal profits

OQ= Equilibrium output (where MC = MR)

OPAQ = total revenue

OGBQ0          = TOTAL COST

PROFITS        = TR- TC

= OPAQ0 – OGBQ0

= GPAB

In the short run, a firm may be in a loss making situation. This is when an equilibrium level of output (MC = MR) average cost > average revenue (AC > ARCP). Here the average cost curve is above the average revenue curve.

It may be caused by increases in cost of production or a reduction in price due to increase in number of firms in the industry since there is free entry and exist.

Illustration of losses in the short- run

abnormal profits 1

Shaded region = losses

OQ0 – equilibrium output

OPAQ0 = total revenue

OGBQ0 = total cost

Loss/ negative profit = TR – TC

=OPAQ0 – OGBQ0

= PABG

Long run equilibrium position of a firm under perfect competition

In the long – run a firm is in equilibrium when it is earning normal profits at a point where MC- MR

Normal points

This is the level of profits just necessary to keep an entrepreneur in a particular line of production. 

Illustration of long- runs equilibrium under perfect competition

abnormal profits 2

This firm is earning of economic profits (normal profits). The condition for long – run equilibrium (profit maximization) of a firm under perfect competition is where P = AR=MR=MC=AC=D.

It’s should be noted that when firms in an industry are earning economic profits, the abnormal profits will attract new firms into the industry leading to an increase in the output of the industry which will have an effect of lowering prices in the industry and the demand curve for the firm will shift down wards say from P1, to P2 or even as seen below.

abnormal profits 3

If the firms in an industry are making losses some of them will stop producing and fall out of the industry. This will reduce the industrial output and result into an increase in price and a shift of the price line upwards. The firms will begin earning normal profits

Equilibrium of an industry

Under perfect competition an industry is in equilibrium when there is no tendency for the size of the industry to charge i.e. when no firms which to leave the industry and no firms which to join or enter the industry. 

Break even and shut down points of a firm

If firms in an industry are earning economic profits, this will attract other films to join the industry resulting 8into increase in industrial output and a downward movement of the price line to a point where AC curve touches the AR.

The breakeven point of a firm is that point where the firm is just able to cover the average total cost (AC) i.e. when the firm is earning normal profits at a point where price is equal to average cost. At this point the firm is not earning any economic profits nor is it incurring any losses but earning normal profits that will keep it in a given production line.

The shut down point of a firm is the point when a firm is just able to cover the average variable costs of production and at that point the average revenue is equal to the average variable cost.

If the price falls below this level, the firm will stop production and fall out of the industry because it cannot even cover the variable costs of production.

 abnormal profits 4

B is the breakeven point of the firm (where MC=AC). At this point, the firm is earning normal profits. It is able to cover the costs of production and average revenue = average cost.

Point S is the shut down point of the firm where AVC= MC. If price falls below the shut down point, the firm won’t be able to cover even the variable cost because AR (price) is less than AC. The firm will stop producing and quit the industry.

However, many firms under perfect competition will think of closing their businesses after reaching the shut down point. In the short run, these firms run these firms might continue operating and producing because of the following;

ADVANTAGES OF PERFECT COMPETITION.

1.Under perfect competition, there’s an optimum allocation of resources as the price charged by an individual firm is equal to the marginal cost.

2.In the long run, the firm produces at full capacity. It produces the maximum output possible and at the lowest point of the average cost curve and the depicts an efficient allocation f resources because production is at optimum level.

abnormal profits 5

3.Under perfect competition, resources are free to move from one firm to another where they are better paid (perfect mobility of F.O.P). The efficient firms will employ the resources and the inefficient ones will incur losses and quit the industry.

4.Under perfect competition there are many firms in the industry because there is free entry. There is a large total output which results into low price paid for the commodity by the consumers. Scarcity is not heard of in perfect competition.

5.Under perfect competition each firm produces a similar product to that produced by the rest of the firms in the industry; there is a lot of competition which leads to improvement in the quality of the products. In order to maintain or increase its sales the firm has to produce a commodity and the good quality.

6.Since the commodity is homogenous there are no funds wasted on advertising the commodity and the product differentiation in form of branding, coloring are not present. This reduces operational costs.

7.It promotes consumer sovereignty since the consumer is the price maker and the producer is the price taker.

8.There are many employment opportunities created due to many firms that join the industry.

9.Abnormal profits in the short- run can be used to expand the size of the firm.

10.Due to perfect knowledge in the market, consumer ignorance is reduced.

11.Absence of transportation cost reduces production costs in general.

Disadvantages

1.Due to the presence of many firms, each firm produces very small output hence mo firm may enjoy expansion economies of output.

2.It is based on unrealistic assumptions e.g. no government intervention perfect mobility of factors of production and therefore does not exist in reality.

3.In the long – run when the firm is earning normal profits expansion of the business may be impossible as there are no profits to re- invest in the business. Research may also be impossible because of lack of adequate capital.

4.It can lead to exhaustion of resources since there’s no government intervention to control resource exploitation.

5.As the price is determined by total supply and demand in the industry ie when supply is high, prices go down and vice versa. This will lead to instability of prices in the economy.

6.Since inefficient firms are pushed out of the industry, unemployment may result.

7.Since the demand curve is perfectly elastic, the firms are unable to carry out price discrimination.

8.There’s limited consumer choice since there are no varieties as only homogenous products are produces.

 

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ASSIGNMENT : MARKET STRUCTURES-S.5 assignment MARKS : 10  DURATION : 1 week, 3 days

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