UNIT 6: Economics
Market structures and the equilibrium of the firm
This unit should enable you to understand and explain
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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.
2.
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.
3.
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.
4.
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 idealtype 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:
5.
What can consumers do to ensure that their purchasing decisions are
well-informed ones?
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.
Quantity (thousands of
Jumpers per day)
(a) Jumper Industry
AR
=MR
Price (pounds per jumper)
Price (pounds per jumper)
Price (pounds per jumper)
Demand, Price and Revenue in
Perfect Competition
Quantity (jumpers per
day)
Quantity (jumpers
per day)
(b) Neat Knits' demand, average (c) Neat Knits' total
revenue and marginal revenue
revenue
Fig 6.1
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 and total cost
(pounds per day)
Total Revenue, Total
Cost and Profit
Quantity (jumpers per day)
(a) Revenue and cost
Fig 6.2
(b) Economic profit and loss
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 and marginal
cost (pounds per jumper)
Marginal Revenue, Marginal Cost
and Profit-maximising
Quantity (jumpers per day)
Fig 6.3
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 9 th
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.
Quantity (jumpers per day)
(a) Economic profit
MR
Quantity (jumpers per day)
(b) Normal profit
Fig 6.4
Price and cost (pounds per jumper)
MR
Price and cost (pounds per jumper)
Price and cost (pounds per
jumper)
Price and cost (pounds per jumper)
Three Possible Profit Outcomes
in the Short Run
Quantity (jumpers per
(c) Economic loss
day)
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:
2.
Which other firms that you are familiar with have virtual monopolies
in their markets?
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 headto-head as they battle for each other’s market share, using every trick in the marketing
book.
3.
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.
4.
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.
Retailers may differentiate themselves by their location, appearance, the stock they
sell, their prices, opening hours or their service. They aim to create a difference
between themselves and their rivals so that their customers wouldn’t dream of going
anywhere else.
Activity:
In what ways does your own organisation try to differentiate itself and
its products from other firms in the market?
These are the most common imperfect markets. They stem from two of the
assumptions we made when setting up perfect competition earlier in the unit.
When we reduce the number of participants in a market, power and influence
can be established.
Product differentiation can also give firms power in their markets.
Given the conditions in these imperfect markets, we can make the following
important assertion.
In imperfect competition the demand curve facing the individual firm will be
downward-sloping.
Firms in these markets will not lose all their customers if they put their price up,
although they may lose some. If they lower their prices they will probably attract
more customers which may lead to increased revenues.
EQUILIBRIUM OF THE FIRM
Assuming that imperfect competitors also want to maximise profit we can now
consider the most profitable output for an imperfect competitor. Consider a village
with only one hairdresser. This is an example of a local monopoly. How does the
monopolist behave?
A Monopoly's Output and
Price Decision
Table 6.1
The table consists of some fictitious costs and revenues for a hairdresser. The costs
and revenues behave in the way we have established already. To find the maximum
profit there are again two possible techniques:
1.
Find the output that gives the biggest difference between total cost and total
revenue.
According to this method and Table 6.1, the business should aim to do 3 haircuts an
hour at a price of £14 each.
2.
Find the output where marginal cost equals marginal revenue.
Using a little mental arithmetic you will find this also occurs at an output of 3 haircuts
an hour at a price of £14 each.
Given the nature of its costs, this firm will be in equilibrium and maximise profits by
selling 3 haircuts an hour at a price of £14 each, leading to a profit of £12 an hour.
This can all be shown diagrammatically.
Price and cost (pounds)
Monopolistic Competition
14
10
3
Quantity
Short run
Fig 6.5
Don’t forget that output will occur where MC = MR.
Activity:
If a firm analyses its costs and revenues and finds that at current levels
of output marginal cost is less than marginal revenue, should the firm
increase output or decrease output?
Our monopolist is doing well and is making the economic/supernormal profit we first
saw earlier in the unit. Now we have to ask a very important question:
Will these profits last?
In some situations the answer will be no. Just like a perfect market, these excess
profits will act like the beam from a lighthouse signalling to other entrepreneurs that
there are rich-pickings to be had here. Another hairdresser will open in the village and
the excess profits will be competed away, leading to lower prices for customers in the
village. This will happen in all imperfect markets unless there is something to stop
new firms from entering a profitable market and competing alongside other
participants.
BARRIERS TO ENTRY
If an industry has significant entry barriers, then firms in the industry can hold on to
the economic or supernormal profits that might be available in the market.
What entry barriers might exist?
Here are some examples of entry barriers.
1. Legal barriers
There may be licences granted to certain firms and not others, as is the case with
broadcasting. Laws related to copyright and patents are put in place to restrict
competition although they may not be completely watertight. Import duties and other
measures may keep firms out of other people’s markets.
Activity:
What effect do these legal barriers have on market prices?
2. Capital
In some industries the cost of entry may be prohibitive due to the very nature of
production and the scale of operation. Entering the world car market would qualify as
an example; electricity generation too, but there are obviously many others.
3. The opposition
Markets dominated by commercial giants with a lot of financial muscle would not be
attractive to a potential new entrant. The cola market would appear to be like this,
although Virgin have recently achieved some success. Challenging Microsoft might
also suggest a commercial death-wish. The cross-Atlantic passenger airline market is
dominated by players who have employed a variety of tactics over the years to try to
keep newcomers out.
4. Know-how
Some industries require an accumulation of know-how or expertise which new
entrants would find difficult to acquire in a hurry. Precision tools or any other
technical engineering market would fall into this category.
5. Natural barriers
Some markets may be too small to attract new entrants. In our earlier example a new
hairdresser may not be attracted into the village if the potential in the market is small.
In some cases it is uneconomical for a particular market to be served by more than
one firm, as we see in the case of the utilities which are sometimes referred to as
natural monopolies.
There are many reasons why new entrants may not appear in profitable markets and,
if this is the case, then those economic/supernormal profits can exist into the long-run.
However, if there is freedom of entry to the market then those excess profits will be
competed away. The demand for the output of an individual firm will fall if there is an
increase in the number of sellers in the market. This is shown in Fig 6.6.
Price and cost (pounds)
Monopolistic Competition
Quantity
Long run
Fig 6.6
Here we have the long-run equilibrium in an imperfect market in the absence of entry
barriers. Output is again taking place at MC = MR which gives us quantity Ql and
Price Pl.
To round things off, it would be useful to establish a few things about this long-run
equilibrium position.
Producers are earning a profit, but only just enough to keep them interested.
Consumers are paying higher prices than they have to. This firm is operating below its
most efficient output. If it produced more, unit costs would come down and so could
prices but this firm is only interested in maximising profit, which it does at price Pl.
Society as a whole will not be happy because potential is being wasted. Firms like this
have excess capacity so they could be more efficient and, if they were, society could
benefit from the more efficient use of resources.
If you compare these outcomes with the outcomes from perfect competition you will
gain an insight into the rationale behind aspects of government economic policy in the
last couple of decades. Economic theory, using very simple analytical techniques, can
be used to support the case for free competitive markets.
Small firms should be encouraged and so should new firms since they increase the
number of potential market participants and promote market efficiency.
Large state-owned monopolies should be broken-up and markets allowed to develop.
The power of organised labour, which is an imperfection in the market, should be
taken away.
Large firms should not be allowed to use their influence in the market against the
interests of consumers.
Efficiency and competition should be encouraged.
Activity:
Investigate prices charged by telephone companies for overseas calls.
Do you think prices would have fallen to current levels if BT had not
been privatised and the telecoms market de-regulated?
Our brief journey through the mysteries of market structure and equilibrium should be
enough to encourage you to look into these issues in a little more detail. We all
function in markets and struggle to survive in them, the more we can understand how
markets operate the more effective we can be in our day-to-day-lives.
CONCLUSION
In this unit we have investigated the behaviour of the firm in different competitive
environments. You should now appreciate the importance of the environment in
determining the type of competition that will occur. The perfect market was shown to
be fiercely competitive with the emphasis on costs and prices. In the long-run, perfect
competition produced favourable outcomes for consumers, firms and society as a
whole. We have seen the kinds of imperfections that can occur in markets and how
firms will adapt to ‘imperfect’ environments. In imperfect markets, costs and prices
are also important but far more important is product differentiation and competitive
strategy. We concluded that in the long-run, imperfect markets produce less desirable
outcomes for consumers and for society as a whole.
REFERENCES FOR UNIT 6
Begg, D et al, Economics, McGraw-Hill, 1997, 5th edition, Ch 9 and Ch 10
Chalkley, Martin, 'Markets & Competition in the NHS', Economic Review, April
1997
Gage, Heather, 'The Circulation War between National Daily Newspapers', Teaching
Business and Economics, Spring 1997
Gore, Chris and Murray, Kate, 'Market Structure and Regulatory Control', ACCA
Students' Newsletter, April 1992
Lipsey, R and Chrystal, K, Introduction to Positive Economics, OUP, 1995, 8th
edition, Ch 12, Ch13 and Ch14
Parkin, M et al, Economics, Addison Wesley Longman, 1997, 3rd edition, Ch 11,
Ch 12 and Ch 13
Shackleton, J, 'Market structures, competition and contestability', Economics and
Business Education, Summer 1995