The Efficiency of Different Market Structures
1. Introduction
The introduction begins by defining market structure and reviewing the theory of the firm. It continues with a discussion of the economic and econometric problems in estimating the efficacy of market structure. Finally, there is a statement of our particular approach and some previews of results. Sections 2 and 3 of the essay only deal with efficiency effects of market structure in the traditional static model. In this model, the price mechanism is the only method of effecting resource allocation. This is a limitation that has been recognized by nearly all economists but which has been very difficult to circumvent. Its consequence is that market stealing behavior by firms cannot be modeled since this changes the industry quantity and costs but not the allocation of resources between firms and industries. Static analysis also assumes perfect knowledge. This is not very unrealistic when applied to single markets for easily observable products, but it is quite unrealistic when applied to an industry. Dynamic models of resource allocation based on imperfect knowledge and bounded rationality are still exceedingly rare and have not been tightly linked to a market structure theory. Static analysis is less unsatisfactory when applied to a comparison of alternative resource allocations in one industry, i.e. before and after a change in its own market structure. But in the following sections of this essay, it will be argued that the static model should still be refined if we are to progress to a more relevant understanding of market structure effectiveness.
In the pure theory of resource allocation, the most significant marker of efficacy is the extent to which an allocation can be termed Pareto optimal. This is said to be achieved with no possible reallocation of resources which will make one person better off without making someone else worse off. Unfortunately, it cannot be asserted with great confidence that the neoclassical model microeconomic theory has a unique mapping of its own concepts onto Pareto issues nor that it is possible to test these maps convincingly. But in the theory of the firm, cost-minimization is widely regarded as the decision which most approximates to an efficacious resource allocation.
The theory of the firm in the context of market structure is an extension of pure resource allocation theory to situations where exchange is mediated by firms producing goods using different technologies. Neoclassical economists have suggested that the earlier perfect competition and pure monopoly models are the most efficient of all market structures. In the former, this is because the price-taking behavior of firms forces them to allocate resources to the point where the factor price equals the factor marginal cost. Step by step modifications of these models to more realistic oligopolistic situations have been attempts to show that certain historical changes in industry structure could in theory lead to a better resource allocation than would have occurred in the original competitive or monopoly situations. At each stage, it must be shown in terms of.
2. Perfect Competition
2.3 Short Run Efficiency Short run equilibrium in a PC market is achieved when the firm is earning normal profit only. This occurs when AR=MC at q where MC cuts MR from below. If MC>MR, it will lead to a decrease in profit; if MC<MR, it will lead to an increase in profit. Normal profit in the PC market is defined when TR=TC. Although PC is short run allocatively and productively efficient, it is certainly not so in the long run. This is due to the nature of the market and the ease with which firms can enter and exit.
2.2 Firm Behavior As all firms are profit maximizers, they will tend to produce at an output level where marginal cost is equal to marginal revenue (MC=MR). The only abnormality firms have to do in PC markets is to make more or make less for monetary reasons. If the firm’s market situation has altered and this specific price level of the product is not attainable, then the firm should pull out of the market if the AR<ATC and it is not covering its costs.
2.1 Brief explanation A perfectly competitive market is a market which meets the following six conditions: both buyers and sellers are price takers, there is freedom of entry and exit into the industry, there is a homogeneous product for all firms, and there is perfect knowledge. Firms have perfect knowledge about price and product, and finally, there is no buyer or seller large enough to influence price.
3. Monopoly
The efficiency of monopoly has often been questioned. Monopolies can make supernormal profits in both the short and long run. However, this does not mean that consumers are worse off. The loss of allocative efficiency only occurs if the product is being under-produced or overpriced. For a normal good, the income elasticity of demand is positive. Due to the fact that there is no close substitute, an increase in the price of a good will not cause a proportional fall in quantity demanded. This means that the PED and hence the MR curve will be negative. Equilibrium will be achieved at the point where marginal cost cuts the marginal revenue from below, but it will lead to an output that is lower than the allocatively efficient level (MC=AR). This is because the price will always be higher than the marginal cost. Also, productive efficiency is not at all necessary for a monopoly to continue producing. With no threat from potential firms, profits can be made from an inefficiently produced product. Adaptive efficiency is achieved though, as the firm will always try to lower the production costs through technological advancements.
Monopolies, like perfect competition, are also guided by an economic motive. The monopoly seeks to maximize the difference between total revenue and total cost. If profit is the difference between total revenue and total costs, the profit maximization for the monopolist can be shown by the following formula view post pc-3. To maximize profits, the firm will continue to produce the product until marginal revenue is equal to zero. This is the point at which the TR and TC are furthest apart. The demand curve, which is also the Marginal Revenue (MR) curve, is always above the average revenue curve. The MR curve also cuts the x-axis at a point, whether it is elastic or inelastic. From the demand/marginal revenue curve, the firm can ascertain the level of output that will achieve the highest level of profit (the vertical distance between the TR and TC curves).
In a monopoly, there is only one firm in the industry. For this single firm, the demand curve is the industry demand curve, and it is a downward sloping curve. The firm can sell more of its product only by reducing the price at which it can sell the product.
4. Monopolistic Competition
Thus, because of its demand curve, the monopolistic competitor can only sell more by reducing the price. It can sell another unit of output at a higher price, but only by giving up the price differential on all other units that it was previously sold at the higher price. Therefore, marginal revenue is also equal to the price on the next unit of output only. If for each additional unit of output that it sells the marginal cost is greater than the marginal revenue, then the firm can increase profits by reducing the amount of output it is producing. This will continue until marginal cost is equal to marginal revenue. This is exactly the same profit maximizing rule as for the competitive firm.
Monopolistic competition is a market structure that combines elements of monopoly and competitive markets. It is big enough that firms are able to have control over price, but small enough that there are many firms in the industry. This is because no one firm has total control over the industry. Looking at the diagram to the right, you see that the monopolistic competitor can decide to charge a higher or lower price, much like a monopoly. However, it also faces a perfectly elastic demand curve, meaning that if the firm raised the price of its product, consumers would switch to the product of a different firm. Thus, the demand curve is very elastic as it is for a competitive firm.
5. Oligopoly
In analyzing the efficiency of different market structures, we will use game theory model to explain how firms maximize their profits. Game theory is a technique used to analyze strategic behavior of firms. It is based on the theory that if firms know their future actions are dependent on the actions they take today, and they can take into account the future responses of rivals to their current actions, then they can analyze how best to act in their own best interests in the future. The model makes assumptions that each player is rational and intelligent, reasons through the future consequences of current actions, does not cheat unless it is profitable, and that players are well informed about choices of other players. This can be applied to many of the economic situations that can be looked at as a game, and oligopoly is no exception. An oligopoly can be described as a form of a market structure in which only a few companies dominate. This is when a market is dominated by a small number of large firms that together control the majority of the market. This is opposed to a monopoly where only one firm controls the entire market. A key factor in an oligopolistic market is the interdependence of firms. This means that firms consider the options of their rivals when making their own choices.
