Essay COMPARE AND CONTRAST PERFECT COMPETITION, MONOPOLY AND IMPERFECT COMPETITION

Submitted by: K.Nagalaxmi Roll no. 38, Batch 1, MMM, First year. JBIMS, Mumbai.

INDEX
Sr. No. 1 2 3 Particulars Introduction Market Structure Features of Market structure Page No.

INTRODUCTION
Human beings are the central element to all the activities in the world. Their desires, needs and wants, more or less, run our whole world. But the needs and wants are ever increasing i.e. say if you wish to buy a vehicle, you choose two wheeler instead of four wheeler because the money available is insufficient. Once you get a better job, you may think of buying a four wheeler. The point here is when one desire is fulfilled, the individual moves to next higher desire level. In ancient times, before invent of money, people use to exchange goods with each other (barter system) according to their needs and wants. It was done on individual basis or by coming to a common place market where they can exchange goods. In this case supply of what one needs (demands) was not always appropriate because what one needs may not be available with other persons in the market. Money invention along with market development has solved this problem. Today whatever one needs, can be bought from shop owner in market in exchange of money. With that money the shop owner may fulfill his needs and wants. But how is that, what one needs, most of the times is available in the market? This can be explained by Invisible hand doctrine as explained by Adam smith. Adam Smith first recognized how a market economy organizes the complicated forces of supply and demand. He saw the harmony between private profit and public interest, private interest can lead to public gain when it takes place in well functioning market mechanism i.e. under perfect competition and with no market failures, markets will squeeze as many useful goods and services out of the available resources as possible (Samuelson, Nordhaus 2010). But where monopolies or pollution or similar market failures become pervasive, the remarkable efficiency properties of the invisible hand may be destroyed.

To understand how the market functions to maintain demand-supply equilibrium, one needs to know different types of market structures. The different type of market structures are as follows Perfectly competitive market Idealized markets in which firms and consumers are too small to affect the price. Imperfectly competitive market Prevails in an industry whenever individual sellers can affect the price of their output. The major kinds of imperfect competition are monopoly, oligopoly, and monopolistic competition. Monopoly Occurs when one firm, called a monopolist or a monopoly firm, produces an industrys entire output. Oligopoly Occurs where there is a small group of dominant producers. Monopolistic competition Refers to a market in which there are many firms but each sells a differentiated product and so faces a downward sloping demand curve for its own product (Lipsey & Chrystal, 2009)

MARKET STRUCTURE
Market structure is best defined as the organizational and other characteristics of a market (5). Following table shows the features of different market structures. Table 1: Features of different market structures Sr. No 1. a 1. b 1. c 2. a 2. b 3 Features Number of producers Consumer number Size of firms Sellers entry barriers Buyer entry barriers Degree of product differentiation Perfect competition Many Many Small No No Identical products Monopoly One Many Huge Yes No Product without close 4 5. a 5. b 5. c Pricing/ Market power Profit maximization condition Excess profits Economic efficiency P=MR=MC No Yes MR=MC Yes No MR=MC Yes/No (Short/Long) No MR=MC Yes (Long) No Price taker substitute Price maker Monopolistic Competition Many Many Small No No Many real or Perceived differences in product Price taker Oligopoly Few Many As a group, its huge Yes No Differentiation or non differentiated products Price maker

Contd- Table 1: Features of different market structures Sr. No. 6. a 6. b Features Price v/s Marginal cost Price v/s Long run average cost (LRAC) Perfect competition P=MC P= LRAC, hence firm can sustain in the market Monopoly P>MC P>LRAC due entry barriers Monopolistic Competition P>MC P=LRAC Oligopoly P>MC P> LRAC, as few firms hold major market share, firms keep on differentiating 7 Price elasticity of demand Perfectly elastic demand 8 Extent of collusion curve Not present Perfectly inelastic demand curve Not present, single player 9 10 Innovative behavior Degree to which information can flow freely Source: Compiled from references (W1) to (W10) Weak Perfect information Potentially Strong Information not available Yes, to some extent e.g. cartels Weak Perfect information Downward sloping products Elastic or inelastic depending on condition Yes, to greater extent Very Strong Selective

Features of Market Structures

Number of producers/ firms and consumers
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Perfect competition
Infinite consumers with the willingness and ability to buy the product at a certain price. Infinite producers with the willingness and ability to supply the product at a certain price (W7).

Monopoly
In a monopoly there is one seller of the good who produces all the output (W8). Therefore, the whole market is being served by a single firm, and for practical purposes, the firm is the same as the industry. Infinite consumers.

Monopolistic competition
There are many firms in each Monopolistic competition product group and many firms on the side lines prepared to enter the market. A product group is a "collection of similar products" (W9). The fact that there are "many firms" gives each Monopolistic competitive firm the freedom to set prices without engaging in strategic decision making regarding the prices of other firms and each firm's actions have a negligible impact on the market. For example, a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.

Oligopoly
"Few" a "handful" of sellers (W10). There are so few firms that the actions of one firm can influence the actions of the other firms.

Entry and Exit barrier

Perfect competition
It is relatively easy for a business to enter or exit in a perfectly competitive market (W7). As there are no barriers to entry, existing firms cannot derive any monopoly power.

Monopoly
In a monopoly, market, a firm is itself an industry. Therefore, there is no distinction between a firm and an industry in such a market. Entry and exit are difficult in such markets (W8).

Monopolistic competition
In the long run there is free entry and exit. There are numerous firms waiting to enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without incurring liquidation costs (W9). This assumption implies that there are low start up costs, no sunk costs and no exit costs. Oligopoly Barriers to entry are high (W10). The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms.

Degree of product differentiation

Perfect competition
The characteristics of any given market good or service do not vary across suppliers. i.e. homogeneous products (W7).

Monopoly
A monopoly sells a good for which there is no close substitute (W8). The absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive profits.

Monopolistic competition
Monopolistic competitive firms sell products that have real or perceived non-price differences (W9). However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is basically the same - to move people and objects from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many variations even within these categories.

Oligopoly
Product may be homogeneous like steel or differentiated like automobiles (W10).

Pricing/ Market power

Market power is the ability to raise the product's price above marginal cost and not lose all your customers. Specifically market power is the ability to raise prices without losing all one's customers to competitors (W8).

Perfect competition
Perfectly competitive firms have zero market power when it comes to setting prices. All firms in a perfectly competitive market are price takers (W8). The price is set by the interaction of demand and supply at the market or aggregate level. Individual firms simply take the price determined by the market and produce that quantity of output that maximizes the firm's profits. If a perfectly competitive firm attempted to raise prices above the market level all its "customers" would abandon the firm and purchase at the market price from other firms (W8).

Monopoly
A monopoly has considerable although not unlimited market power. A monopoly has the power to set prices or quantities although not both. A monopoly is a price maker (W8). The monopoly is the market and prices are set by the monopolist based on his circumstances and not the interaction of demand and supply. The two primary factors determining monopoly market power are the firm's demand curve and its cost structure.

Monopolistic competition
MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since they are low. Rather, an MC firm has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the firms sells differentiated product (W9). Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not "flat".

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Oligopoly
The distinctive feature of an oligopoly is interdependence (W10). Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market action, a firm must take into consideration the possible reactions of all competing firms and the firm's countermoves.

Profit Maximization
Perfect competition
Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit. In the short term, perfectly-competitive markets are not productively efficient as output will not occur where marginal cost is equal to average cost, but allocatively efficient, as output will always occur where marginal cost is equal to marginal revenue, and therefore where marginal cost equals average revenue. In the long term, such markets are both allocatively and productively efficient (W7).

Monopoly
A Perfectly competitive firm maximizes profits by producing where price equals marginal costs. A monopoly maximizes profits by producing where marginal revenue equals marginal costs (W8). The rules are not equivalent. The demand curve for a perfectly competitive firm is perfectly elastic - flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal 11

revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P.

Monopolistic competition and Oligopoly

Firms generate most profit where marginal revenue is equal to marginal cost.

Price v/s Marginal cost, Short run average cost and Long run average cost
Perfect competition
Equilibrium in perfect competition In the short run Under perfect competition, firms can make super-normal profits or losses (W4).

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In the long run However, in the long run firms are attracted into the industry if the incumbent firms are making supernormal profits (W4). 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 supernormal 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.

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The super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only normal profit is made. Only normal profits made, so producers just cover their opportunity cost. There is maximum possible consumer surplus and economic welfare. Maximum allocative and productive efficiency. Equilibrium will occur where P = MC, hence allocative efficiency. In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency (W1).

Monopoly
Equilibrium in Monopoly In the Short run A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR curve with a MR curve with twice the gradient of AR (W2). The firm is a price maker and has some power over the setting of price or output. It cannot, however, charge a price that the consumers in the market will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below. Assuming that the firm aims to maximize profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

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The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output. In the long run A change in demand will cause a change in price, output and profits. In the example below, there is an increase in the market demand for the monopoly supplier. The demand curve shifts out from AR1 to AR2 causing a parallel outward shift in the monopolist's marginal revenue curve (MR1 shifts to MR2) (W2). We assume that the firm continues to operate with the same cost curves. At the new profit maximizing equilibrium the firm increases production and raises price.

Total monopoly profits have increased. The gain in profits compared to the original price and output is shown by the light blue shaded area.

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Not all monopolies are guaranteed profits - there can be occasions when the costs of production are greater than the average revenue a monopolist can charge for their products (W2). This might occur for example when there is a sharp fall in market demand (leading to an inward shift in the average revenue curve). In the diagram below notice that ATC lies AR across the entire range of output. The monopolist will still choose an output where MR=MC for this reduces their losses to the minimum amount.

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Monopolistic competition
As monopolistic competition is characterized by three attributes: many firms, similar products (but not identical), and free entry. Like monopoly, the market has excess capacity, meaning that it operates on downward sloping portion of the average total cost curve. Also, each firm charges a price above the marginal cost because firms want profit. In monopolistic competition, the firms get profit in the short run (W11). Like this

However, if we consider the long run result, the firm gets zero profit because the marginal revenue becomes equal with demand at equilibrium price (W11). Monopolistic competition does not have all the desirable properties of perfect competition. Because the firms charge price above the marginal cost, there are deadweight losses like that of monopolies. Also, the number of firms may be too small or too large. The ability of policy makers to correct these inefficiencies is limited.

Oligopoly
The kinked demand curve model of oligopoly (W12).

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The kinked demand curve model developed first by the economist Paul Sweezy assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms in the market to a change in its price or another variable. The common assumption of the theory is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match anothers price increase but may match a price fall. i.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm (W12).

If a business raises price and others leave their prices constant, then we can expect quite a large substitution effect away from this firm making demand relatively price elastic. The business would then lose market share and expect to see a fall in its total revenue. If a business reduces price but other firms follow suit, the relative price change is much smaller and demand would be inelastic in respect of the price change. Cutting prices when demand is inelastic also leads to a fall in total revenue with little or no effect on market share.

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The kinked demand curve model therefore makes a prediction that a business might reach a stable profit-maximizing equilibrium at price P1 and output Q1 and have little incentive to alter prices. The kinked demand curve model predicts periods of relative price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits. Short-lived price wars between rival firms can still happen under the kinked demand curve model. During a price war, firms in the market are seeking to snatch a short term advantage and win over some extra market share.

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Price elasticity of Demand

Perfect Competition
Perfectly elastic demand curve, indicating even the slightest change in price will shift the consumer to other producer.

Monopoly

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Perfectly inelastic demand curve, indicating to certain point the price can be increased without losing the consumer.

Monopolistic Competition
Price change results in downward sloping curve.

Oligopoly
Depending on different condition, demand curve can be elastic or inelastic.

Extent of Collusion
Collusion is an agreement among firms to divide the market, set price or limit production.

Perfect Competition
Collusion is not present, as many firms produce identical products.

Monopoly
Collusion is not present, as single player dominates the market. 21

Monopolistic Competition
Collusion is present in the form of cartels.

Oligopoly
Collusion forms the basis of oligopoly.

Degree to which information can flow freely

Perfect Competition
There is perfect knowledge, with no information failure or time lags (W7). Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited. There is no need to spend money on advertising, because there

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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. .

Monopoly
Information is not available because of monopolistic barriers (say legal barriers, patents etc.).

Monopolistic Competition
Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating characteristics of the goods, the good's price, whether a firm is making a profit and if so how much (W9).

Oligopoly
Assumptions about perfect knowledge vary but the knowledge of various economic actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price, cost and product quality (W10).

Examples
Extent of Collusion
Collusion is an agreement among firms to divide the market, set price or limit production.

Perfect Competition

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Large auction of identical goods with all potential buyers and sellers present (W7).

Monopoly
British East India Company; created as a legal trading monopoly in 1600 (W8).

Monopolistic Competition
In many U.S. markets, producers practice product differentiation by altering the physical composition of products, using special packaging, or simply claiming to have superior products based on brand images or advertising. Toothpastes and toilet papers are examples of differentiated products (W9).

Oligopoly
There are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate (W10).

CONCLUSION
There are different market structures depending on various situations and parameters. The two extreme cases of market structure include perfect competition and monopoly. But in reality these structures are not readily seen, instead intermediates between these two are often seen and practiced. This is mainly because of the availability of resources, product demanded, supply of the product, price of the product, number of firms, number of consumers etc. The intermediates (Monopolistic competition and oligopoly) are broadly 24

categorized as imperfect competitions. The market structures have many overlapping features as well as specific/differentiating features. This four market structure helps to explain all the markets operating today in the world. The study of these market structures will help in understanding the functioning of different types of market. It is essential in marketing field, where understanding of market is required to increase sales. It also helps in strategic decision making regarding what to produced and supplied.

REFERENCES
Lipsey & Chrystal, 2009, Economics 11/e, New York, Oxford University Press Inc. Samuelson A Paul, Nordhaus D William, 2010, Economics 19/e (SIE), New York, Tata McGraw-Hill. Website references: 1. http://www.economicsonline.co.uk/Business_economics/Perfect_competition.html

2. http://tutor2u.net/economics/content/topics/monopoly/monopoly_profits.htm 3. http://en.wikipedia.org/wiki/Market_structure 4. http://wapedia.mobi/en/Perfect_competition 5. http://tutor2u.net/economics/revision-notes/a2-micro-market-structures-summary.html 6. "Monopoly." 123HelpMe.com. 05 Apr 2011 http://www.123HelpMe.com/view.asp?id=98294 7. http://en.wikipedia.org/wiki/Perfect_competition

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8. http://en.wikipedia.org/wiki/Monopoly 9. http://en.wikipedia.org/wiki/Monopolistic_competition 10. http://en.wikipedia.org/wiki/Oligopoly 11. http://mrski-apecon-2008.wikispaces.com/Chapter+17+JK+%26+JJ 12. http://tutor2u.net/economics/revision-notes/a2-micro-oligopoly-overview.html

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