Kenya Institute of Management Diploma Course in Management Economics Work Based Assignment Done By: Daniel Mwathe Mugo Student No: NRB-44592 Table of Contents Question2 Market Structures3 Monopoly3 Equilibrium Price and Output3 Price Discrimination5 Advantages of Monopoly5 Disadvantages of Monopoly6 Monopolistic Competition6 Characteristics of Monopolistic Competition6 Equilibrium level6 Oligopoly7 Features of Oligopoly8 Competition and Collusion8 Duopoly: A type of Oligopoly8 Perfect Competition9 Features/Characteristics or Conditions9 Importance of Perfect Competition10
Advantages of perfect competition11 Disadvantages of Perfect Competition11 Kinked Demand Theory of Oligopoly12 References13 Question 1. Market Structures a)Define Market Structures b)Write short Notes on the following i)Monopoly ii)Monopolistic Competition iii)Perfect Competition iv)Oligopoly v)Duopoly c)Explain the concept of a Kinked Demand Curve Market Structures A market Structure is the manner in which a market is organized, based largely on the number of firms in the industry. The four basic market structure models are: perfect competition, monopoly, monopolistic competition, and oligopoly.
The primary difference between each is the number of firms on the supply side of a market. Both perfect competition and monopolistic competition have a large number of relatively small firms selling output. Oligopoly has a small number of relatively large firms. And monopoly has a single firm. In Market Structures, there can be Imperfect Competition or Perfect Competition. Imperfect Competition differs from perfect competition in that there may be one or small number of firms dominating the market. There are three main types of Imperfect Competition. a)Monopoly )Monopolistic Competition c)Oligopoly Monopoly A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource.
For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. Equilibrium Price and Output As with firms in other market structures, a monopolist will maximize profit where MC = MR. In the short run, the monopolist may make sub-normal profit, normal profit or supernormal profits. However, in the long run, since there are barriers to entry of new firms, the supernormal profits that are made by the monopolist will not be chipped away.
As for the monopolist who makes normal profits or abnormal profits in the short run, it will make supernormal profits in the long run. In the long run, the firm will make Supernormal profits only. This is because there are barriers to the entry of new firms. Price Discrimination Discrimination Monopoly (price discrimination) is said to exist when a business is able to charge two or more different prices for the same project. There are three varieties of price discrimination: i)First degree Price Discrimination ii)Second degree Price Discrimination iii)Third degree Price Discrimination
Price Discrimination in different markets is separated by: •Time •Distance •Age •Consumer’s Ignorance Advantages of Monopoly •No risk of over production •There is enough capital for research •Reduction in price of good •Efficient use of resources •Control over entire market •Others are price takers •Only producer of a particular product or service Disadvantages of Monopoly •Exploitation of consumers •Restriction of consumer’s choice •Absence of competition leads to inefficiency •Increase in price of product •Exploitation of labour i. e. when price is greater than marginal cost. Monopolistic Competition
This occurs when a large number of sellers produce differentiated products. This market structure resembles Perfect Competition in that there are many sellers, none of whom have a large share of the market. It differs from perfect competition in that the products sold by different firms are not identical. Differentiated products are ones whose important characteristics vary. Personal computers, for example, have different characteristics such as speed, memory, hard disk, modem, size, and weight. Because computers are differentiated, they can sell at slightly different prices. Characteristics of Monopolistic Competition There are quite a large number of firms and buyers •Product differentiation •Free entry to and exit from the market •High selling costs Equilibrium level As with other market structures, firms will maximize their profits where MC = MR. The diagram will be the same as for the monopolist, except the AR (demand curve) and MR curve will be elastic. In the short run, firms under monopolistic competition may make super normal profits or sub normal profits as shown in the figures below. Oligopoly Oligopoly is imperfect competition among the few; it applies to an industry that contains only a few competing firms.
Each firm has enough market power to prevent it from being a price-taker, but at the same time, each firm is subject to enough inter-firm rivalry to prevent it from considering the market demand curve as its own. In most modern economies, this is the dominant market structure for the production of consumer and capital goods as well as many basic industrial materials such as steel and aluminium. Services, however, are often produced in industries containing a large number of firms – although product differentiation prevents them from being perfectly competitive.
Also, the absence of symmetry prevents them from being monopolistically competitive. Since some firms’ products are closer substitutes for each other than other firms’ products, firms tend to take account of the behaviour of their closest competitors. Features of Oligopoly i)Oligopolies might produce virtually identical products and compete with one another through price. It is more common, however, for them to compete through advertising and product differentiation. ii)Barriers to entry – There are various barriers to the entry of new firms. They are similar to those under monopoly.
The size of the barriers however will vary from industry to industry. iii)Independence of the firm – Because there are only few firms under oligopoly, each firm will have to take account of the others. This means that they are mutually dependent. They are interdependent. Each firm is affected by its rival’s actions. Each firm will be affected by its rivals; decisions. Likewise, its decisions will affect its rivals. Firms recognize this interdependency. This recognition will affect their decisions. iv)Homogeneity/differentiated goods. v)Non-price Competition – Sometimes oligopolies prefer to engage in on-price competition. It takes the form of product differentiation. •Physical product differentiation – produce a product that is more attractive, innovative than the product produced by its rivals. •Advertising – An oligopolistic firm advertises to persuade consumers to buy its product rather than those of its rivals so as to increase the demand for its product. •After sales services – Provide delivery facilities to customers, such as delivering the product to the homes of consumers. •Free offers – For example, if customers buy a television, a walkman will be given as a gift. i)Price War Competition and Collusion Oligopolies are pulled in two different directions. The interdependence of firms may make them wish to collude with each other. If they could come together and act as a monopoly, they could jointly maximize industry profits. When oligopolists agree (formal or informal) to limit competition between themselves, they may set output quotas, fix prices, limit production or development, or agree not to ‘poach’ each other’s market. Duopoly: A type of Oligopoly A true duopoly is a specific type of oligopoly where only two producers exist in one market.
In reality, this definition is generally used where only two firms have dominant control over a market. In the field of industrial organization, it is the most commonly studied form of oligopoly due to its simplicity. Features of a Duopoly •Collusion may be a possible feature •Price leadership by the larger of the two firms may exist – the smaller firm follows the price lead of the larger one •Highly interdependent •High barriers to entry •Cournot Model – French economist – analysed duopoly – suggested long run equilibrium would see equal market share and normal profit made •In reality, local duopolies may exist
Advantages of a Duopoly •Close competition •Competition in prices as a direct reaction to the other producer •Interaction •Simplicity Disadvantages of a Duopoly •In some cases, duopolies will reach a Nash Equilibrium, and prices will not drop. •Two huge corporations in one market will make it very difficult for smaller firms to gain recognition or a market share. This means many new firms will die out before they are able to generate any new competition. •The lack of new firms can mean a lack of new products, and a market can go stale.
Perfect Competition Perfect competition occurs in an industry when that industry is made up of many small firms producing homogeneous products, when information is perfect and when there is no impediment to the entry and exit of firms. Features/Characteristics or Conditions i)Large number of firms – The basic condition of perfect competition is that there are large number of firms in an industry. Each firm in the industry is so small and its output so negligible that it exercises little influence over price of the commodity in the market.
A single firm cannot influence the price of the product either by reducing or increasing its output. An individual firm takes the market price as given and adjusts its output accordingly. In a competitive market, supply and demand determine market price. The firm is price taker and output adjuster. ii)Large number of buyers – In a perfect competitive market, there are very large number of buyers of the product. If any consumer purchases more or purchases less, he is not in a position to affect the market price of the commodity. His purchase in the total output is just like a drop in the ocean.
He, therefore, too like the firm, is a price taker. In the figure below, PK is the market price determined by the market forces of demand and supply. The price taker firm has to adjust and sell its output at Price PK or OE. iii)The product is homogeneous – Another provision of perfect competition is that the good produced by all the firms in the industry is identical. In the eyes, of the consumer, the product of one firm (seller) is identical to that of another seller. The buyers are indifferent as to the firms from which they purchase.
In other words, the cross elasticity between the products of the firm is infinite. iv)No barriers to entry – The firms in a competitive market have complete freedom of entering into the market or leaving the industry as and when they desire. There are no legal, social or technological! barriers for the new firms (or new capital) to enter or leave the industry. Any new firm is free to start production if it so desires and stop production and leave the industry if it so wishes. The industry, thus, is characterized by freedom of entry and exit of firms. )Complete information – Another condition for perfect competition is that the consumers and producers possess perfect information about the prevailing price of the product in the market. The consumers know the ruling price, the producers know costs, the workers know about wage rates and so on. In brief, the consumers, the resource owners have perfect knowledge about the current price of the product in the market. A firm, therefore, cannot charge higher price than that ruling in the market. If it does so, its goods will remain unsold as buyers will shift to some other seller. i)Profit maximization – For perfect competition to exist, the sole objective of the firm must be to get maximum profit. Importance of Perfect Competition Perfect competition model is hotly debated in economic literature. It is argued that the model is based on unrealistic assumptions. It is rare in practice. The defenders of the model argue that the theory of perfect competition has positive aspect and leads us to correct conclusions. The concept is useful in the analysis of international trade and in the allocation of resources. It also makes us understand as to how a firm adjusts its output in a competitive world.
Advantages of perfect competition •Optimal allocation of resources •Competition encourages efficiency •Consumers charged a lower price •Responsive to consumer wishes: Change in demand, leads extra supply Disadvantages of Perfect Competition •Insufficient profits for investment •Lack of product variety •Lack of competition over product design and specification •Unequal distribution of goods & income •Externalities e. g. Pollution Kinked Demand Theory of Oligopoly The kinked-demand theory is illustrated in the image below and applies to oligopolistic markets where each firm sells a differentiated product.
According to the kinked-demand theory, each firm will face two market demand curves for its product. At high prices, the firm faces the relatively elastic market demand curve, labelled MD1 in the figure below. Corresponding to MD1 is the marginal revenue curve labelled MR1. At low prices, the firm faces the relatively inelastic market demand curve labelled MD2. Corresponding to MD2 is the marginal revenue curve labelled MR2. The two market demand curves intersect at point b. Therefore, the market demand curve that the oligopolist actually faces is the kinked-demand curve, labelled abc.
Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labelled adef. The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P. The oligopolist faces a kinked-demand curve because of competition from other oligopolists in the market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own.
The oligopolist will then face the more elastic market demand curve MD1. The oligopolist’s market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower-priced products provided by the other oligopolists in the market. Consequently, the demand for the oligopolist’s output falls off more quickly at prices above P; in other words, the demand for the oligopolist’s output becomes more elastic. If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce their prices as well.
The oligopolist will then face the relatively less elastic (or more inelastic) market demand curve MD2. The oligopolist’s market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. When oligopolists follow each other’s pricing decisions, consumer demand for each oligopolist’s product will become less elastic (or less sensitive) to changes in price because each oligopolist is matching the price changes of its competitors. References ECONOMIC GLOSSARY (2011).
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Economics. 18th Edition. New Delhi: Tata McGraw Hill Publishing. LIPSEY & CRYSTAL. (2007). Economics. 11th Edition. New York: Oxford University Press. BAUMOL, W. J. & BLINDER, A. S. (2004). Economics: Principles and Policy. 9th Edition. Mason, Ohio: Thompson South-western. WIKIPEDIA (2011). Duopoly [WWW]. Available from: http://en. wikipedia. org/wiki/Duopoly Accessed: 22/10/2011 CLIFFSNOTES (2011). Kinked Demand Theory of Oligopoly [WWW]. Available from: http://www. cliffsnotes. com/study_guide/KinkedDemand-Theory-of-Oligopoly. topicArticleId-9789,articleId-9778. html Accessed: 22/10/2011