The problem with perfect competition is that supernormal profit is not achievable in the long-run. Discuss. Students need to lay out the assumptions of a perfectly competitive market, highlighting the absence of barriers to entry.
Perfectly competitive markets have four basic assumptions (McConnell and Brue, 2008):
Large number of sellers: under perfect competition there are many sellers in a market. They offer their products in large international or domestic markets. For example, farm commodities, foreign exchange and stock markets.
Standardised goods: all the goods on offer are homogenised. No differentiation like brand names or other non price competition takes place as the price of all the products is set and the buyer is indifferent to the seller because the price is the same for all.
Price takers: the market determines the price of the product in this market. Because the contribution of the individual seller is so small that his/her change in price does not influence overall market price. Therefore all sellers are price takers as they cannot change the market price but adjust their price to it.
Absence of entry and exit barriers: in perfectly competitive markets there are no barriers to entry or exit. Therefore, anyone can enter or exit a market without any problem.
When one analyses the fourth assumption it becomes clear that absence of entry barriers can lead to a situation where supernormal profits cannot be enjoyed. According to Bain (1956, p. 52):
“The advantages of established sellers in an industry over potential entrant sellers, these advantages being reflected in the extent to which established sellers can persistently raise their prices above a competitive level without attracting new firms to enter the industry.”
In the short run, it is assumed that the number of sellers is fixed; therefore supernormal profits can be enjoyed, when marginal cost MC is equal to marginal revenue; however, the average cost or AC is less than MC in short term. In the long run, however, new firms can enter the market and loss making firms exit the market (Market Structures, 2007 [Online]). As a result supernormal profits are competed away and:
Price=average revenue AR=AC=MC=MR
Question B: Is monopoly power, in reality, the ability to charge as much as possible or the ability to make supernormal profit in the long-run?
Students must discuss the assumption about a monopoly. The key here is that the demand curve, which they should draw, for a monopolist is downward sloping and that if they increase prices quantity demanded will fall. Therefore, monopoly power is about barriers to entry
It is wrongly assumed that because a monopolist can manipulate prices and output, the monopolist can charge the highest possible price. In reality monopolists charge a price where they get maximum profit. The monopolist seeks maximum total profits not the highest price. Some higher prices can lead to lower sales and reduced total revenue. The monopolist seeks maximum total profit not maximum unit profit (McConnell and Brue, 2008).
A monopoly market assumes:
- There is a single seller in the market
- There are no close substitutes
- Since there is a single seller a monopolist is a price setter
- There are different entry barriers, including economic, technological, legal or even customer loyalty
Since a monopolist is the only seller in the market it is the price maker; as a result the AR curve is the market demand curve: a downward sloping curve. The monopolist wields market power and can increase sales by reducing price. Average revenue tends to fall as output increases. In monopolies, marginal revenue is always less than average revenue. The monopolist can only remain profitable in the area when demand is elastic. As opposed to perfect competition, where demand is perfectly elastic, monopolies can operate in the price region where demand is elastic. This is because marginal revenue becomes negative when demand is inelastic.
Usually, monopolists restrict their output in order to maximise profits by producing where marginal cost is equal to marginal revenue: MC=MR (Market Structures, 2007 [Online]).
As can be seen in the diagram, a monopoly produces less quantity of output to maximise its profits. There are inefficiencies visible in these types of markets, and since there are severe entry barriers, therefore, the quantity produced by the monopoly is determined based on total maximum profits. If a market is quite small and entry costs are high then usually it is not profitable for potential entrants into the market (Collander, 2007).
Graph 1: Inefficiency of monopoly for profit maximisation in the long-run
Question C: Why do Oligopolists compete on things other than price?
Oligopolistic markets are close to monopolies; however, there are several features that make them different from other types of competition (Arnold, 2008):
- Few large producers: oligopolies have only a limited number of large players in the market.
- Homogenous and differentiated products: in oligopolies products can be homogenous like fuel or differentiated like athletic shoes. Differentiated product oligopolies indulge in non-price competition relying heavily on advertising.
- Price makers: although oligopolists can each set their individual price but there is mutual interdependence because each producer has to anticipate the reaction of others with a change in price, advertising, product or production. Thus oligopolies represent a mutual interdependence and strategic behaviour.
- Entry barriers: in oligopolies, entry barriers are high, as in monopolies, because technological knowhow and economies of scale can make it difficult for others to enter.
- Mergers: this is another feature which leads to the creation of oligopolies as is the case with pharmaceutical companies or entertainment companies.
In oligopolies it has been experienced that producers usually have non-price competition, especially in the differentiated products. Breit and Ransom (1971, p. 60) explain thus:
“The basis for differentiation is broad indeed, for it is not important that differences in products be real, they may simply be imagined by the consumer. All that matters is that consumers behave as if the products are not alike. If they judge the two as being different, they will presumably pay some additional sum to buy the one they like most, regardless of the actual characteristics of the goods.”
since all their decisions about their products are interdependent and any change in price, product, output or marketing can get a reaction from other competitors, oligopolists tend to collude rather than compete with one another. In the absence of strict government regulations, oligopolists can combine forces with their rivals and cartelise. In price competition, lower prices benefit the consumer and the individual producers don’t make sufficient profits, therefore oligopolists tend to collude. Instead of indulging in price war, oligopolies have the same high price or a market leadership/fellowship structure, where the dominant producer may set the price for smaller players (Stephan, 2001 [Online]).
Question D: The sports shoe market; a classic case of oligopoly. Discuss how they compete and what barriers to entry exist.
Students should identify that in the global sports shoe market there are only a few truly global brands, that they tend not to compete on price but on developing brand loyalty through sponsorship of teams, stars etc and through advertising. Students should then discuss the difficulty and the economic resources needed to compete at this level and how this might deter competitors.
For over twenty years sports shoes industry has been dominated by three major brands: Nike, Reebok and Adidas. In 2005 Adidas merged with Reebok in an acquisition of $3.8 billion. This was done to increase Adidas’ share in the US market. The international sports shoes market is an oligopoly between Nike and Adidas-Reebok now (Oligopoly Watch, 2005 [online].
In such a market, price wars are usually detrimental, as was the case with Pepsi and Coke. Nike and Adidas-Reebok have not indulged in a price war because consumers of these products are not influenced by price; they are comparatively inelastic to change in prices. The demand curve in such a situation is kinked and therefore inelastic to decrease in prices, and the organisations don’t get any significant number of customers because of reduced prices.
Nike and Adidas-Reebok resort to other non-price competition to get higher profits and increase in market share. Brand image and brand loyalty is one way of gaining higher market share for this several strategies are adopted by these organisations (McConnell and Brue, 2008). This includes celebrity endorsements: for example, the Nike logo is worn by both Federer and Nadal. Similarly, sports teams are supported by these companies (Chadwick and Walters, 2008).
Since these organisations control large segments of global consumer markets, it is not easy for new entrants to enter or even old players to leave.
As has been seen in the case of Reebok and Adidas, Reebok’s acquisition was carried out to have a greater presence in the global market through combined synergies of both organisations. In addition, research and development for Nike and Adidas and economies of scale create advantage for the companies and create entry barriers which make it very difficult for other producers to enter the market. Nike, for example, has distribution deals with major retailers which ensure shelf-space for its products.
- Explain the key differences between perfect competition and Imperfect (monopolistic) competition.
Students should identify that in imperfect competition that products are broadly similar but not homogenous therefore firms are price setters and not price takers.
Perfect competition and monopolistic competition are much more similar than oligopoly or monopoly models (Mansfield, 2003). However, there are some key difference between pure markets and monopolistic markets:
Product differentiation: in perfect competition all products are homogenous and perfect substitutes of each other. On the other hand, in monopolistic markets there is product differentiation that allows the producers a flexibility of price setting in the market. Despite the fact that a large number of producers exist in the market, each individual producer or seller can set a price or ask for a premium for their products if consumers are willing to pay extra for that particular product (Morgan, 2003). This is the reason that monopolistic competition has firms competing on non-price competition. According to Chamberlin:
“when products are differentiated, buyers are given a basis for preference, and will, therefore, be paired with sellers, not in a random fashion (as under pure competition), but according to these preferences . . . so that the whole is not a single large market of many sellers, but a network of related markets, one for each seller . . . Under monopolistic competition, however, his market being separate to a degree from those of his rivals, his sales are limited and defined by three new factors: (1) his price, (2) the nature of his product, and (3) his advertising outlays” (1958, p. 71)
Lack of random relationship between buyers and sellers: in perfectly competitive markets there is a random relationship between buyers and sellers; however, in monopolistic competition, since there are a number of substitutes of the product, the interdependencies are not very strong. But companies can create their own niche and cater to a certain segment of the society.
Profit and product tradeoff: in pure competition normal profits for firms is at the lowest point of their average total cost curve, while for imperfect or monopolistic markets they are at the point to falling marginal costs which may indicate excess capital and inefficiency; however, it should be kept in mind that it also shows a tradeoff between lower costs and greater choice in price setting or product differentiation.
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