The Economics of Strategy
Question one:
Compare and contrast between perfect competition and monopoly forms of market. Do you agree with the statement ‘In the real world there is no industry which conforms precisely to the economist’s model of perfect competition. This means that the model is of little practical value’. Illustrate with a diagram and explain the short-run perfectly competitive equilibrium for both (i) the individual firm and (ii) the industry. (50 marks)
Two extremes are often represented by monopoly and perfect competition in the market structures discussed in economics. The one extreme represented by perfect competition markets demonstrates the attainment of efficiency in an industry with extensive existence of competition and absence of market control. On the other hand, monopoly market structure represents the other extreme in that it demonstrates the inefficiency brought about by the absence of competition and rigid control of the market by a single market player (Machovec, 2002). The comparison and contrasting between perfect competition and monopoly markets involves the focus on the various characteristics that distinguish each of the two forms of market structures.
The first step in the analysis of the two forms of market structures looks at the various differences between these market structures. Perfect competitive markets have various characteristics that distinguish it from monopoly markets. To start with, perfect competitive market firms and consumers are always price takers. This means that neither the firms nor the consumers dictate the prices prevailing in the market as they are determined by the prevailing market forces. Consequently, there exists an environment of non-exploitation between the consumers and the firms. Another distinguishing characteristic between perfect competition market structure and monopoly market structure is that firms in perfect competition often sell as much as they want at the prevailing prices in the market. In this regard, there is often a small supply by firms relative to the market. The fact that many firms exist in a perfect competition is the main reason for the existence of competition in this market structure. The actions by individual firms do not affect the market as there are many other firms in the same market.
The marginal revenue of firms in perfect competitive market structure equals the price in the market. Therefore, an individual firm maximizes profit by equating the marginal revenue with its marginal cost. This, therefore, means that for firms in the perfect competitive market structure, price equals to marginal cost. The monopoly market structure represents complete control by a single player or firm. The supply-side of the market is fully controlled by a single firm. This means that this single firm has all the powers to determine the quantity and hence the prices for his products. Certainly, the individual firm creates enormous barriers to entry into the market by other players. The barriers could also be enforced by other forces outside the individual firm say from the government.
A pure monopoly is therefore a single supplier of the products in the market under consideration. The monopoly market structure has a negatively slopped demand function. The monopoly market does not present any chance for another player to enter as serious barriers have been established by the monopoly firm or through existing law. Contrary to the perfect competitive market where each individual firm has no control over the prices prevailing in the market, a monopolist firm fully determines the prices prevailing in the market. The analysis of perfect competitive market and monopoly market structures can be assessed based on four major areas namely number of firms, nature of the products, freedom to enter and or exit the market as well as the existence of perfect in formation.
The number of firms in a perfect competitive market structure is infinite. Indeed, there are numerous small firms making up the whole industry at any one given time. The small firms have absolutely no influence on the industry meaning that they are only price takers. Their lack of market control means that they have to supply their products at the prices determined by interaction of demand and supply. The reverse is true for a monopoly firm. This single firm is extremely large in size and typically boasts of extreme power and control in the industry. The firms in a perfect competitive market do not produce goods that are regarded as substitutes; rather they produce goods that exactly the same as those of other firms in the industry. Therefore, the consumers can buy from any firm without experiencing any form of shift in quality. On the contrary, the products of a monopoly firm are perfectly unique and do not have any close substitutes whatsoever.
The mobility of firms in perfect competitive markets is perfect in that at any one given moment, a firm can enter or exit the market at choice. No barriers exist for firms in perfect competitive markets. This is not the case with monopoly markets. A monopoly firm has the full control of the industry and the market it exists implying that no other players can be able to enter such a market. The monopoly firm has either amassed extensive strength to take over the whole industry or possess the patents on the production of specific products produced by the monopoly firm. The other distinction between perfect competition and monopoly market is the information availability and awareness of the firms. Firms in perfect competition have the same information as that possessed by other firms in the market. Additionally, the firms have similar production technology. On the contrary, a monopoly firm possesses information that is unknown to other firms.
In spite of the numerous differences that exist between perfect competitive markets and monopoly markets, there are some similarities between the two forms of markets. To start with, the firms in the forms of market structures seek to maximize profits (Djolov, 2006). Without such profits, the firms cannot have the motivation to operate. The profit maximization goal is attained through either attainment of normal profits or through supernormal profits. Firms in perfect competition often enjoy normal profits warranting their continued existence. On the other hand, the monopoly firm can make supernormal profits or normal profits depending on the decisions it makes. In reality, monopoly markets enjoy supernormal profits as a result of the inefficiencies they create in the market to ensure low supply thus increasing the demand for its products. Consequently, prices will rise for such products leading to supernormal profits.
In reality, perfect competitive market structure does not exist. The five main requirements for the existence of a perfect competitive market are not realistic in real life. Perfect competition does not exist. The real world is characterized with firms selling products with diverse differentiation levels. There are significant barriers to entry into any industry in real world especially the start-up capital. Indeed, significant factors in real world hamper the existence of a perfect competitive market structure. For instance, it is impossible for consumers and firms to possess similar information at any one given point in time. Although neo-classicalists have argued that the market must at one point in time arrive to a level of perfect competition, it is impossible to have a perfect situation (Nielsen, 2012). Although perfect competitive model does not exist, it is regarded as an ideal scenario for conservatives and neo-classical economists. Therefore, the best description for perfect competitive market is a fantasy.
Short-run equilibrium for a firm in perfect competitive market
In the short-run, total fixed costs are constant. Therefore, a change in total cost is brought about by variations in variable costs. Marginal cost leads to changes in total cost also known as the total variable cost (Desmond et al., 2002). The average cost curve assumes a U-shape just like the marginal cost curve. There is a rise in marginal cost curve and average cost curve with an increase in production leading to the existence of the law of diminishing marginal productivity. Demand curve also known as the average revenue curve intersects with the supply curve also known as the marginal cost curve in the short run at points E’ and E leading to a profit maximizing level P=MC. When the firm produces even after point E’ it is able to increase revenue. Point E is the level of profit maximization while E’ is the level of loss minimization.
Short-run Equilibrium for an industry in perfect competitive market
A firm and industry are distinct entities though co-related. In the perfect competitive market, several firms exist forming the industry.
The equilibrium market price in the short-run is determined by relationship between market supply and market demand. The price P1 represents the market-clearing price which is always taken by each of the firms in the industry. The constant nature of the market price means that average revenue curve become the marginal revenue curve. As all the firms do not make supernormal profits in the short-run, the profits made depend on position of the short run cost curves. There are firms which experience sub-normal profits as average total costs are more than market price prevailing while other firms make normal profits meaning total cost equals total revenue.
Question 2
Explain the features of oligopoly market. Examine and illustrate why there is a kink in the demand curve in an oligopoly market? How does kink demand curve explain price rigidity in oligopoly? (50 marks)
Oligopoly markets comprise small firms which are generally mutually exclusive. Each firm in an oligopoly market considers the expected reaction that other firms will have. Oligopoly term is made of two Greek words, Oleg’s which means a few and Pollen means to sell. Therefore, oligopoly describes a situation whereby there are a few firms involved in selling activities. The form of competition described in oligopoly markets is such that there are few firms involved in the competition. The few firms in the market either produce homogeneous products or close substitute goods. However, the products are not perfect substitutes. As there is no strict border line between many and few, oligopoly market structure is often thought of as having between two firms to ten firms (Agarwala, 2008). There are various characteristics associated with the oligopoly market structure.
The first feature is the interdependence trait. This typically means that oligopolistic firms exhibit interdependent tendencies in their decision making process. The fact that there are a few competitors means that a slight change in price as well as products’ unique characteristics can profound impact on the profitability of rival firms. Therefore, an action by one firm is often followed by retaliation by other firms in the oligopoly market. The decisions made by an individual firm thus focus on both the prevailing market demand as well as the actions by other firms in the market. An individual firm in an oligopoly market cannot afford to operate in total disregard of the actions by other rival firms in the industry. This is an indication of a high level of interdependence among the few firms in oligopoly market structure.
Another important characteristic of oligopoly market structure is the level of relevance attributed to selling costs and advertising. Firms in oligopolistic market structure often undertake very aggressive advertising. The firms in oligopoly market also defensive weapons that are used to gain a larger share of the market as well as experience a maximization of sales in the market. To fulfill such profit maximization goals through increased sales, it is common for firms in oligopoly market structure to undertake extensive advertising and numerous other promotion techniques. To this end, promotion and advertising are important components of oligopoly market structure. Indeed, a firm under oligopoly market considers expenditure in advertising and product promotion as an integral life-blood of such a firm’s existence.
Oligopoly markets also comprise of firms with tendencies of group behavior. This based on the extensive levels of interdependence among firms in oligopoly market structure. Oligopoly markets also exhibit indeterminateness of the demand curve. In particular, this characteristic originates from the interdependence nature of oligopolistic firms. When there is a mutual interdependence among the firms in the marker, there is typically a high level of uncertainty for all the firms in the market. The existence of mutual interdependence in the market leads to the creation of uncertainty for all the firms. Consequently, no individual firm is in a position to predict the effect of price-output decision adopted by other firms. Additionally, a firm cannot hope that other rival firms will maintain the prices upon changing individual prices. This characteristic erodes the determinateness aspect of the demand curve for firms in oligopolistic markets (Arnold, 2006). Therefore, the demand curve for firms in oligopolistic markets is well known and relates to the numerous quantities of product able to be sold at diverse levels of prices with unknown quantity and uncertain demand curve.
The other characteristic of oligopolistic market has to do with the elements of monopoly depicted by this form of market structure. Firms in oligopolistic market depict some reasonable levels of monopoly status. Basically, firms in oligopolistic markets undertake intense product differentiation thus imposing control on a large portion of the market through production of differentiated products. Therefore, the firm acts as a monopolist in the determination of price and output for the products sold. Furthermore, oligopolistic market structure boasts of price rigidity. There is price rigidity for firms in oligopolistic markets. A price cut by one firm leads to retaliation by other firms immediately. Therefore, price wars exist among the different firms. The outcome of such retaliatory activities for the firms is a condition of price-rigidity.
The use of the kinked-demand curve in oligopoly markets explains the level of price rigidity in oligopoly markets. The kind has two segments which depict a more elastic segment with price increases while the other segment represents a relatively less elastic part for price decreases. The relative elasticity of the two parts of the kink depends on the level of interdependent decisions of the firms under consideration. The existence of the more elastic segment is brought about by existence of other firms in the industry which are likely to retaliate after increases in price for oligopolistic firm. This leads to erosion of market share as well as massive decreases in the quantities demanded. The part of less elasticity in the kinked-demand curve portrays the likely of other firms to match any price decreases by a firm in oligopolistic market. This eventually leads to no gain in terms of market share. Furthermore, there is a minimal increases in quantity demanded.
Due to the existence of uncertainties in the oligopoly market, businesses undertake measures to prevent such occurrence through various ways. Collusion is one such method adopted by firms in oligopolistic markets. The desire by each of the firms in oligopolistic markets to know the actions of each other in advance on certain occurrences encourages collusion among firms in oligopoly markets. The firms often get together and make agreements aimed at protecting themselves from each other. Collusion leads to the creation of cartels sometimes leading to powerful firms.
Agarwala, S.K. (2008). Microeconomics. Excel Books India.
Arnold, R.A. (2006). Microeconomics, Concise Edition. Cengage Learning.
Desmond, K.G., Joll, C. & Lynk, E.L. (2002). Industrial Organization: Competition, Growth and Structural Change. Psychology Press.
Djolov, G. (2006). The Economics of Competition: The Race to Monopoly. Psychology Press.
Klein, A. (2007). Comparison of the Models of perfect competition and monopoly under special consideration of innovation. GRIN Verlag.
Machovec, F. (2002). Perfect Competition and the Transformation of Economics. Routledge.
Nielsen, R. (2012). There is (Almost) No Such Thing As Perfect Competition. A new Economic Theory. Retrieved on Monday, January 13, 2014 from

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