Theory of Market

• Perfect Competition: Nature and Relevance

• Monopoly and Monopolistic Competition
• Oligopoly
What is Perfect Competition?
Pure or perfect competition is a theoretical market structure in which
the following criteria are met:
 All firms sell an identical product (the product is a "commodity" or
"homogeneous").
 All firms are price takers(they cannot influence the market price of
their product).
 Market share has no influence on prices.
 Buyers have complete or "perfect" information—in the past, present
and future—about the product being sold and the prices charged
by each firm.
 Resources for such a labor are perfectly mobile.
 Firms can enter or exit the market without cost.
Key Characteristics
Perfectly competitive markets exhibit the following characteristics:
 There is perfect knowledge, with no information failure or time lags
in the flow of information. Knowledge is freely available to all
participants, which means that risk-taking is minimal and the role of
the entrepreneur is limited.
 Given that producers and consumers have perfect knowledge, it is
assumed that they make rational decisions to maximize their self
interest - consumers look to maximize their utility, and producers look
to maximize their profits.
 There are no barriers to entry into or exit out of the market.
 Firms produce homogeneous, identical, units of output that are not
branded.
 No single firm can influence the market price, or market conditions.
Benefits of Perfect Competition
 Because there is perfect knowledge, there is no information failure and
knowledge is shared evenly between all participants.
 There are no barriers to entry, so existing firms cannot derive
any monopoly power.
 Only normal profits made, so producers just cover their production cost.
 There is no need to spend money on advertising, because there is
perfect knowledge and firms can sell all they can produce. In addition,
selling unbranded goods makes it hard to construct an effective
advertising campaign.
 There is maximum possible:
Consumer surplus
Economic welfare
 There is also maximum choice for consumers.
How it works?
 Firms are attracted into the industry if the
already present firms are making
supernormal profits.
 This is because there are no barriers to entry
and because there is perfect knowledge.
 The effect of this entry into the industry is to
shift the industry supply curve to the right,
which drives down price until the point
where all super-normal profits are
exhausted.
 If firms are making losses, they will leave
the market as there are no exit barriers, and
this will shift the industry supply to the left,
which raises price and enables those left in
the market to derive normal profits.
Disadvantages
 Profit margins are fixed by
demand and supply. Firms
cannot thus set themselves apart
by charging a premium for their
product and services.
 For example, it would be
impossible for a company like
Apple Inc. to exist in a perfectly
competitive market because its
phones are pricier as compared
to competitors.
 The second disadvantage of
perfect competition is the
absence of economies of scale.
Limited to zero profit margins
means that companies will have
less cash to invest in expanding
their production capabilities.
Monopoly
 A monopoly refers to when a company and its product offerings
dominate one sector or industry.
 Monopolies are result of absence of any restriction or restraints, a
single company or group becomes large enough to own all or
nearly all of the market (goods, supplies, commodities,
infrastructure, and assets) for a particular type of product or service.
 The term monopoly is often used to describe an entity that has total
or near-total control of a market.
 Monopolies typically have an unfair advantage over their
competition since they are either the only provider of a product or
control most of the market share or customers for their product.
Characteristics
 Profit Maximizer: Maximizes profits.
 Price Maker: Decides the price of the good or product to be sold,
but does so by determining the quantity in order to demand the
price desired by the firm.
 High Barriers: Other sellers are unable to enter the market of the
monopoly.
 Single seller: In a monopoly, there is one seller of the good, who
produces all the output. Therefore, the whole market is being served
by a single company, and for practical purposes, the company is
the same as the industry.
 Price Discrimination: A monopolist can change the price or quantity
of the product. They sell higher quantities at a lower price in a very
elastic market, and sell lower quantities at a higher price in a less
elastic market.
Causes of Monopoly
 Capital requirements: Large investments of capital, perhaps in the form of
large research and development costs, limit the number of companies in
an industry.
 Technological superiority: A monopoly may be better able to acquire,
integrate and use the best possible technology in producing its goods while
entrants either do not have the same level of expertise. Thus one large
company can often produce goods cheaper than several small
companies.
 No substitute goods: A monopoly sells a good for which there is no close
substitute. The absence of substitutes makes the demand for that good
relatively inelastic, enabling monopolies to extract positive profits.
 Control of natural resources: A prime source of monopoly power is the
control of resources (such as raw materials) that are critical to the
production of a final good.
 Advertising: Monopoly can invest in large scale marketing and advertising,
thus reducing any competition.
Monopolistic Competition

 Monopolistic competition is a middle ground

between monopoly and perfect competition (a purely
theoretical state), and combines elements of each.
 All firms in monopolistic competition have the same, relatively
low degree of market power; they are all price makers.
 Firms in monopolistic competition tend to advertise heavily.
 Firms in monopolistic competition typically try to differentiate
their product in order to achieve in order to capture above
market returns.
Characteristics
 Product differentiation: firms use size, design, color, shape,
performance, and features to make their products different. For
example, consumer electronics can easily be physically
differentiated.
 Many firms.
 Freedom of entry and exit.
 Imperfect information: No sellers or buyers have complete market
information, like market demand or market supply.
 Market power: Market power means that the firm has control over
the terms and conditions of exchange. A firm can raise its prices
without losing all its customers.
 Independent decision making: Each firm independently sets the
terms of exchange for its product. The firm gives no consideration to
what effect its decision may have on competitors
Advantages
 There are no significant barriers to entry; therefore markets are
relatively contestable.
 Differentiation creates diversity, choice and utility. For example,
a typical high street in any town will have a number of different
restaurants from which to choose.
 The market is more efficient than monopoly but less efficient
than perfect competition - less allocatively and less productively
efficient. However, they may innovative in terms of new
production processes or new products.
 Retailers often constantly have to develop new ways to attract
and retain local customers.
Key Differences
 Key difference with monopoly:
In monopolistic competition there are no barriers to entry. Therefore
in long run, the market will be competitive, with firms making
normal profit.
 Key difference with perfect competition:
In Monopolistic competition, firms do produce differentiated
products, therefore, they are not price takers (perfectly elastic
demand). They have inelastic demand.
Oligopoly
 An oligopoly is an industry which is dominated by a few firms. In this
market, there are a few firms which sell homogeneous or
differentiated products.
 Also, as there are few sellers in the market, every seller influences
the behavior of the other firms and other firms influence it.
 Oligopoly is either perfect or imperfect/differentiated. In India, some
examples of an oligopolistic market are automobiles,
steel, aluminum, etc.
 Entry barriers include high investment requirements, strong
consumer loyalty for existing brands and economies of scale.
 A monopoly is one firm, duopoly is two firms and oligopoly is two or
more firms. There is no precise upper limit to the number of firms in
an oligopoly, but the number must be low enough that the actions
of one firm significantly influence the others.
Characteristics
 Few firms: Under Oligopoly, there are a few large firms although the exact
number of firms is undefined. Also, there is severe competition since each
firm produces a significant portion of the total output.
 Barriers to Entry: Under Oligopoly, there are barriers to entry like patents,
licenses, control over crucial raw materials, etc. These barriers prevent the
entry of new firms into the industry.
 Non-Price Competition: Firms try to avoid price competition due to the fear
of price wars and hence depend on non-price methods like advertising,
after sales services, warranties, etc. This ensures that firms can influence
demand and build brand recognition.
 Interdependence: Under Oligopoly, since a few firms hold a significant
share in the total output of the industry, each firm is affected by the price
and output decisions of rival firms. Therefore, there is a lot of
interdependence among firms in an oligopoly.
 Nature of the Product: Under oligopoly, the products of the firms are either
homogeneous or differentiated.
 Examples of Oligopolies
 Oligopolies are common in the
airline industry, banking, brewing,
soft-drinks, supermarkets and music.
 For example, the manufacture,
distribution and publication of
music products in the UK, as in the
EU and USA, is highly concentrated,
with a 3-firm concentration ratio of
around 70%, and is usually
identified as an oligopoly.
 In India the petroleum and gas
industry is dominated by Indian Oil,
Bharat Petroleum, Hindustan
Petroleum, and Reliance
Petroleum.
 The telecommunication industry is
dominated by Vodafone-Idea, Jio,
and Airtel.
Competition in Oligopolies
 When competing, oligopolists prefer non-price competition in order to
avoid price wars.
 A price reduction may achieve strategic benefits, such as gaining market
share, or deterring entry, but the rivals will simply reduce their prices in
response.
 This leads to little or no gain, but can lead to falling revenues and profits.
 Non-price competition is the favored strategy for oligopolists because price
competition can lead to destructive price wars. Examples are:
 Trying to improve quality and after sales servicing, such as offering
extended guarantees.
 Spending on advertising, sponsorship and product placement is very
significant to many oligopolists.
 Sales promotion, such as buy-one-get-one-free, is associated with the large
supermarkets, which is a highly oligopolistic market, dominated by three or
four large chains.
Advantages
 Oligopolies may adopt a highly competitive strategy, in which case
they can generate similar benefits to more competitive market
structures, such as lower prices. Even though there are a few firms,
making the market uncompetitive, their behavior may be highly
competitive.
 Oligopolists may be dynamically efficient in terms of innovation and
new product and process development. The super-normal profits
they generate may be used to innovate, in which case the
consumer may gain.
 Price stability may bring advantages to consumers and the macro-
economy because it helps consumers plan ahead and stabilizes
their expenditure, which may help stabilize the trade cycle.