This Unit Should Enable You to Understand and Explain

UNIT 6: Economics

Market structures and the equilibrium of the firm

This unit should enable you to understand and explain

• The meaning of perfect competition
• Equilibrium of the firm under perfect competition
• The meaning of imperfect competition
• The equilibrium of the firm under imperfect competition
• The different economic outcomes arising in different types of market

In this unit we will study the behaviour of the firm in different competitive environments.

Just like human beings, firms change their behaviour according to the environment they find themselves in. A firm will behave very differently in a highly competitive market than it will in a less competitive one. We will begin the unit by looking at the most intensively competitive market we can think of, one where no participant, including the individual firm, has power or influence. This kind of market structure is called Perfect Competition.

KEY ASSUMPTIONS BEHIND PERFECT COMPETITION

1. A large number of buyers and sellers.

A competitive market needs a lot of participants to keep competition healthy. In the perfect market there will be so many participants that no individual buyer or seller is able to dictate price. Price will emerge through the interaction of market forces as we described in unit 2. The market price will rule and if any seller tries to offer goods or services for sale at a higher price they will sell nothing since there are plenty of other sellers in the market charging market prices, for buyers to do business with. So, in this kind of market, firms will be price-takers and they will be at the mercy of market forces.

1. An identical product

The product traded in the market must be identical or homogeneous. There must be no real or perceived difference between what one seller is offering for sale and what all the others are offering for sale. Price will be the only relevant variable in this kind of market not product differentiation.

Activity:Can you think of three markets that you are familiar with which deal in identical products?

Consumer goods markets rarely deal in identical products, but you will find identical products in the money markets, the foreign exchange market and in commodity markets for things like sugar or gold.

1. Free entry to and exit from the market

In perfect competition there will be nothing to stop a new firm from entering the market if it sees a profitable opportunity. Existing players in the market will not be able to keep newcomers out. This will keep competition healthy and ensure that there are always enough firms in the market to ensure assumption number one is in place.

Similarly, if firms see better opportunities elsewhere, then they are free to leave the market and go right ahead.

1. Perfect knowledge

Every participant in the market has full and complete knowledge of what is on offer, who is selling, who is buying and the prices they are charging. This will guarantee that sellers trying to charge more than the going price will sell nothing. In this ideal-type market, ignorance doesn’t exist. Naturally, most sellers in the real world are glad that it does and would prefer a little more of it!

Activity:What can consumers do to ensure that their purchasing decisions are well-informed ones?

1. No transport costs

If there are no transport costs in our market, then whether you live Warrington, Wales or the Isle of Wight, the product should cost the same. The assumption backs-up the idea that there will only be one price in this type of market and that is the market price.

In the market for goods, transport costs are a reality but in some service markets and, particularly in financial markets, transport costs may be zero or close to zero.

These are the key assumptions behind the idea of a perfectly competitive market. Such a market may not exist anywhere in reality however, that shouldn’t bother you and it certainly doesn’t bother an economist! We are about to build a theoretical model of how a hypothetical firm might behave. We need to establish a well-defined framework in which our model can operate. As we develop and test our theories using our model we can relax some, or all, of the assumptions that we made earlier and see the effects. This is a scientific approach to understanding firms and markets.

How will perfect competition affect demand for the output of a firm?

Given the features of perfect competition we can make the following important assertion:

The demand curve facing an individual firm will be horizontal.

Demand, Price and Revenue in Perfect Competition

The firm must accept the market price and it can sell as much as it wants to at this price. The firm is too small to have any impact on the market. There is no danger of it flooding the market and affecting prices because it is insignificant compared to the market as a whole. There is also no danger of it charging a price which is lower than the market unless the owners of the firm are irrational. Would you rather sell your entire output for a price of say, £5 a unit or sell it for £4.50 a unit? There is no point in charging £4.50 since it will just reduce your revenues from the operation. You can sell as much as you like in this market for the market price, there is no need to undercut it.

I hope you are convinced that the demand curve facing the firm in perfect competition will indeed be horizontal.

Activity:Compare the demand curve facing the individual firm in perfect competition and the demand curve facing the industry as a whole (the demand curve for the product).

EQUILIBRIUM OF THE FIRM

There are many possible corporate objectives but in this subject we narrow it down to one.

We are going to assume that firms are only interested in one thing, and that is maximising their profit.

Given our assumption regarding profit maximisation, then all we have to do now is to consider at what level of output the firm should operate to maximise those profits. If you believe that they should just operate flat-out then you are thinking more like an accountant and you may not have remembered some important issues from unit 5. In all kinds of markets diminishing returns will set in at a certain level of activity, driving costs up and reducing profitability. Our maximum profit potential will occur before this point, but where?

Look at Fig 6.2.

Total Revenue, Total

Cost and Profit

The table consists of some fictitious costs and revenues from a firm in the woollens

industry. These costs and revenues behave in the way we have established already. To

find the maximum profit there are two possible techniques:

1. Find the output that gives the biggest difference between total cost and total revenue.

Using this method and Fig 6.2 the business should aim to produce and sell 9 jumpers per day.

2.Find the output where marginal cost equals marginal revenue.

Look at Fig 6.3 below.

Marginal Revenue, Marginal Cost

and Profit-maximising

Here you can see the marginal approach. If we match marginal cost with marginal revenue (which requires just a little arithmetic in this case) you will find that they equate at £25 with the level of output at 9 jumpers per day.

Maximum profit occurs where MC = MR

Whether you approach the problem looking at totals or marginal units you will reach the same conclusion.

Activity:If a firm analyses its costs and revenues and finds that at current levels of output marginal cost is greater than marginal revenue, should the firm increase output or decrease output?

Given the nature of its costs, this firm will be in equilibrium and maximise profits when it produces 9 jumpers per day, selling them for £25 each.

At this level of output you are selling the 9th jumper for £25 even though it costs you £25 to produce it. You maybe think this isn’t a good idea and that the firm would be better off just selling 8 jumpers instead.

It is a good idea when you understand what economists include in their definition of cost. In economics, costs of production include all the costs of employing all the inputs in the operation. The cost of employing the labour, the cost of the premises, the cost of the capital employed, the cost of the raw materials and power and also the cost of the entrepreneur’s time and effort. So, included in the price we charge for each jumper, will be a return for all of the inputs used in the process including a little profit for the owner of the business.

The amount of profit we include in our costs of production is called normal profit and it represents just enough profit to keep the entrepreneur interested. It should include a return for the time the entrepreneur puts in, a return on the capital he or she has invested and an additional return for the risk that the entrepreneur is exposed to in the business venture.

Activity:What would an entrepreneur tend to do if their business was returning less than ‘normal’ profits?

You should now be convinced that it will be a good idea to make and sell that 9th jumper for £25. It includes just enough additional profit to make it worthwhile. Of course you would prefer to sell it for £26 but you would be quite happy to sell it for £25.

THREE POSSIBLE PROFIT OUTCOMES

Our analysis so far suggests that if we want to maximise profit in a perfect market we will increase output up to the point where MC = MR. Whilst this profit-maximising rule will hold for all firms, not all firms will make the same level of profit at any point in time. Look at the three diagrams in Fig 6.4.

Three Possible Profit Outcomes

in the Short Run

The firm on the left is doing well. It would be happy to supply the market at a price of £20.33p, and would make normal profits at that price. The market price is £25 so I’m sure that they are delighted to be in this position. The extra profit they are earning, over and above normal profit, is called economic, or supernormal profit.

Firms in this position in a perfect market should make the most of these extra profits because they won’t last. Due to perfect knowledge and the absence of entry barriers to the market, new firms are bound to enter and compete for these excess profits.

As new firms come into the market, the forces of supply and demand will be set in motion. Supply on the market will increase and price will be competed down. New firms will only stop being attracted into the market when the economic/supernormal profits have been competed away completely.

Now look at the firm on the right. This firm is competing in a market where the price of a jumper is £17. Unfortunately, at the profit-maximising output of 7 for this firm, it costs £20.14p to produce a jumper. The firm is losing money however many jumpers it produces a week. No private sector firm would put up with this for long and something would have to be done to try to turn things around.

The only variable under the control of the firm in this kind of market is its own costs. If it can become more efficient, it may be able to pull those average costs down and turn a loss into a profit. If it cannot improve the situation this firm will exit the market.

Activity:Why can’t this firm adjust its pricing strategy or improve its marketing to eliminate losses?

The situation shown on the left-hand diagram cannot last and the situation shown on the right-hand diagram is also short term. The only logical long-term position for the industry is shown in the middle diagram where neither losses nor economic/supernormal profits are being made.

In a perfect market the long-term equilibrium position will occur when normal profits are earned. This is just enough to keep firms in the industry.

Let’s put that another way. Looking at that middle diagram again you can see that prices couldn’t be lower. If they were then firms would make losses and leave the industry. Consumers in this market are getting the product at the lowest possible price consistent with a reliable source of supply.

A second point is worth making too. Notice that in the middle diagram production is taking place at minimum average total cost, a point we identified in unit 5 as the technical optimum. In the long-run, under conditions of perfect competition, industry equilibrium will tend to occur at this very efficient level of output. The resources of the economy could not be used in a more efficient way, on average, by the firms in this industry.

Perfect competition seems to deliver almost perfect outcomes for all concerned.

Producers are earning a profit, but only just enough to keep them interested. They would be happier with higher prices but the market has made sure that they only get the bare minimum.

Consumers are getting the lowest possible prices.

Society as a whole can be happy that perfectly competitive markets will ensure that there is no wasteful resource utilisation. Production will be efficient. Resources that could be more usefully employed elsewhere will not be tied-up by this kind of market.

That concludes our analysis of the firm in this very competitive environment. We can now go on to look at different environments in the knowledge that they are unlikely to deliver results as good as these.

IMPERFECT COMPETITION

Imperfect competition occurs whenever one or more of the features of a perfect market are absent. Therefore there are a number of possible types of imperfection that can be observed in markets.

TYPES OF MARKET IMPERFECTION

1. Monopoly

A monopoly exists when there is only one seller in a market. This seller will have the power to influence prices or the quantities offered for sale in its market and so will be in an entirely different situation to the firm operating under perfect competition.

Although literally a monopoly exists when there is only one seller, in practice we are more likely to see virtual monopolies, markets that are dominated by one large firm. Until recently BT had a virtual monopoly in the telecommunications market. Microsoft has a virtual monopoly in PC operating systems, Sky has a very powerful position when it comes to satellite TV and there are many other possible examples.

Activity:Which other firms that you are familiar with have virtual monopolies in their markets?

1. Duopoly

A duopoly exists when there are only two sellers in the market. Once more, we are unlikely to find markets with literally two players but we can find markets that are dominated by two firms. In the detergent business we have Unilever and Proctor and Gamble. In the cola market Coke and Pepsi dominate. You can be certain that these firms have some power and influence in their market. They are likely to clash head-to-head as they battle for each other’s market share, using every trick in the marketing book.

1. Oligopoly

This kind of market is extremely common in the UK. Whenever we find a few large firms dominating the market we can describe it as an oligopoly. Generally, the large firms in markets like this need a minimum market share of around 15% to be one of the major players, which means that markets of this type will have somewhere between three and seven participants. These markets have other characteristics too. There will be heavy advertising and branding, an emphasis on image-building including the use of logos, symbols and colours; frequent promotional activity and occasional price-wars. Oligopolists prefer not to compete on price if they can avoid it since it can lead to downward price spirals that leave all of the players in the market worse off. Oligopolists would much rather engage in non-price competition and this accounts for the branding, advertising and promotional activity referred to earlier.

There are many examples of markets like this in the UK. Take a look at a typical High Street. We have the banks and the pub on the corner which is probably owned by one of the big brewers. The petrol station belongs to one of the major oil companies. We will see some fast food outlets, McDonalds, Burger-King, KFC and maybe a Pizza Hut. The supermarket business is also clearly oligopolistic. The list of oligopolistic markets is a very long one.

Activity:List three more markets that are dominated by a few powerful sellers.

The players in this kind of market all have influence and power. They will be able to influence prices and people’s perceptions. It is not like the perfect market we saw earlier in this unit and would require different analysis. Some of the most interesting recent research in microeconomics concerns the behaviour of oligopolists and oligopolistic markets.

1. Monopolistic competition.

In this kind of market there are many sellers of the product but each seller is offering a unique product or, to put it another way, a differentiated product. The meal you get in one restaurant will be different to the meal in another (unless it is part of an oligopolistic chain like Burger King). Services offered by different solicitors may differ. The dresses on sale in one shop in the High Street will be different from those in another. This kind of competition is also very common.