Sample Essay on Understanding Market Structures

Understanding Market Structures

Introduction

Market structure is the manner in which industries are organized. There are four main types of market structures, namely 1) perfect competition, 2) Monopoly, 3) Monopolistic competition, and 4)oligopoly, Market structures are compared and contrasted based on the number of firms, class of product, ease of entry or exit, level of market power, and level of government intervention (Redmond, 2013). The goal of this paper is to analyze the four types of market structure to help Illinois City understand how these market structures operate.  This will enable them to analyze the real situations in the City and understand the measures that the state government should take in addressing the challenges and anomalies so as to provide a level playing ground for their market.

Types of Market Structures

Perfect Competition

Perfect Competition is a market scenario where there are several firms operating independently from each other but producing one homogenous product. There is free entry and exit of firms occasioned by few or no barriers to entry and exit (Redmond, 2013). In this type of competition, firms lack market power, which means no firm has the ability to control the price but they can only take the price offered by the market. Economists define firms under perfect competition as price takers. The market price is purely determined by the forces of demand and supply and not by the decisions of individual firms. In addition, there is little government control or influence. A good example of a perfect market is the agricultural industry where there are several firms producing identical products for sale, such as milk processing industries, which produce similar products such as cheese, fresh milk, yoghurt, butter, etc. (O’Connor, 2004).

 Monopolistic Competition

Monopolistic competition is a type of market structure where there are many firms dealing in differentiated products, that is, products similar in nature but not identical. Entry and exit of firms is easy since there are few barriers (Behringer, 2014). This market structure is characterized by market rivalry and firms try to raise their competitive edge through advertising which popularizes their products, creates customer loyalty, and influences customers to buy their goods (Garcia & Sorolla, 2014). The pricing decisions by the firms are informed largely by the availability of substitute goods. Owing to the high level of competition, there is little government intervention. A good example of a monopolistic competition is the fast foods industry where there are several specialized fast-food restaurants selling related foods such as pizzas, hamburgers, chicken, ice cream, etc (Redmond, 2013).

Oligopoly

Oligopoly is a type of market structure where there are a few firms, about 3 or 4 dominating the production of a particular commodity. A modern definition of oligopoly is any industry where four leading companies control at least 40% of the total output in a given industry. Oligopolies are further classified into main categories namely differentiated oligopoly and pure oligopoly. In differentiated oligopoly, firms produce products that are almost similar but not identical (O’Connor, 2004). The automobile is one such example where for instance Ford, General Motors, and Chrysler in the United States dominate the market but deal in different models of vehicles. In pure oligopoly, firms produce a homogenous product. This is mostly seen in industrial goods such as steel and aluminum industries (Redmond, 2013).

There are high barriers to entry, which tend to discourage other firms from entering the market. Such barriers are high costs for capital, research, and promotions. Brand loyalties also hinder new forms by increasing the market power of the oligopolists (O’Connor, 2004). Interdependent pricing is a common feature in oligopoly as competing firms are forced to match the price changes by their rivals. There is a lot of government intervention here as government attempt to reign over illegal and anticompetitive tendencies by firms. Some of these illegal tendencies include collusion by firms (Behringer, 2014).

Monopoly

A monopoly is a market structure where there is one company that is the sole maker of a certain good or service. A typical modern definition of monopoly is a market structure where one firm controls 80% to 90% of the market for a particular commodity (O’Connor, 2004). Entry barriers are very prevalent in this market structure and it is hard for new firms to enter the market. Such barriers are high cost of initial capital and technology. Economies of scale, which is not enjoyed by new entrants, is also a key barrier. There is a lot of government intervention in a monopoly to exert control on product pricing, quality, and availability. Government control becomes necessary here owing to the fact that the prices and profits of a monopoly are not influenced by the actions of competing firms. Monopolies have been grouped into four categories namely natural, technological, government, and geographic (Behringer, 2014).

A natural monopoly is seen in instances where one firm has the ability to produce a certain product more efficiently than its competitors are. This firm capitalizes on the technical economies of scale, which significantly reduces its production cost per unit. Most of the large telephone firms have enjoyed natural monopoly for many years. Other natural monopolies are companies dealing in public goods, which have been allowed by many governments such as electricity and garbage collection (Redmond, 2013).

A technological monopoly happens where one firm adopts a new technology, which only it can utilize in the production process. New technologies are always patented and the investor enjoys exclusive rights to use such a technology for a period that could run up to twenty years (Sukhatme, 2014).

A Government Monopoly where there is a government agency, which is the sole producer of a certain product or service. Most city authorities are the sole dealers in the supply of public goods such as water and sewerage (O’Connor, 2004). A good example of a monopoly that had been in existence in Illinois is ComEd , the biggest electricity supplier in Illinois. We will review this monopoly later in this paper and track its path as well as the measures that the Illinois authorities have taken to address this matter.

A geographic monopoly will be experienced where there is one firm that provides a product or service to a certain geographic region. This is a common city in remote locations that may only support one supplier i.e. there is a limited market size and here the early bird catches the worm. This type of monopoly is diminishing with time as a result of spread of e-commerce, mail order processing, and improved transport and communication infrastructures (O’Connor, 2004).

Entry Barriers in a Market

Firms are in the market to make profits and to increase their wealth. However, where there are low barriers to entry, the profits will attract new competitors into the industry. The entry of new firms will saturate the market thereby driving the prices of commodities down. This will eliminate the economic profits earned by firms.

The relationship between entry and exit and the long run profitability of the firm has been studied by many authors. Where entry barriers are non-existent, any level of profitability by firms over and above the competitive norm will most likely attract new entrants. This means that in the absence of entry barriers, any long run profitability will be an incentive to entry (Redmond, 2013).

If a monopolist is earning a profit, the existence of high barriers to entry shields the company from direct competition and as a consequence, the company enjoys long-run economic profits. However, sometimes long run profits can be influenced by demand and cost conditions (Redmond, 2013).

Potential entrants in markets where entry barriers are low will induce competitive pressures on the existing firms, which have dominated the market for some time. This means that there will be little need for competition laws to intervene in such a market to control firms with market power. However, where there are barriers to entry, firms with market power have taken a dominant position and are better placed to exert to exert anti-competitive tendencies on the market (Rodger & MacCulloch, 2015).

Oligopolists are characterized by a strong incentive to collude and raise their prices. However, a firm can only gain of it alone can lower its price or raise the quality of its product owing to the fact that the firm is faced by a demand curve with more elasticity than that of the industry. This causes a conflict that makes it very hard to sustain collusive arrangements. It is very hard for oligopolistic firms to have a successful collusion against the interests of consumers where more rivals in the market exist, it is costly to prevent competitors from giving a secret price cut, or entry barriers are low (Rodger & MacCulloch, 2015).

The Price Elasticity of Demand and Pricing of Products

Price elasticity of demand is expressed as the percentage change in the quantity demanded for a commodity over the percentage change in price. For relatively elastic demand, a small percent change in the price of the commodity will result in a greater percentage change in the quantity demanded. In inelastic demand, the reverse is true. Although price elasticity of demand is not easy to compute in a normal situation, it is easy to observe its effects. Market structures have an effect on the prices of commodities as well as the costs associated with that price (Rodger & MacCulloch, 2015).

In oligopoly, where products are heterogeneous, firms differentiate their products to earn more revenue. Companies can increase their prices to the extent that there are fewer substitutes, which means the price elasticity of demand is low. There is a relationship between fewer substitutes, lower price elasticity of demand, and more pricing power (Garcia & Sorolla, 2014).

In monopolistic competition, there are several medium sized firms that are under pressure to be innovative in order to differentiate their products from those of their rivals. This means it is very easy for a firm in monopolistic competition to take away sales from its competitors through introduction of price distracting strategies. Therefore, the price elasticity of demand under monopolistic competition is high or we just say that the demand is highly elastic to changes in price (Garcia & Sorolla, 2014).

A monopoly is characterized by one seller of a commodity, which lacks very close substitutes. This means that the demand of the commodity will not be much affected by a change in price therefore tends to be inelastic or exhibits little elasticity. However, the demand curve in a monopoly will not be perfectly inelastic since consumers may be influenced by the price to buy more or less of the commodity. When the price increases, they may opt to buy less and when price decreases, they may opt to buy less (Rodger & MacCulloch, 2015).

Under perfect competition, price strategy is not very common. The price elasticity of demand for every company is perfectly elastic. It is in the form of a horizontal function, indicating that the products are perfect substitutes. Each firm must produce at minimum cost and sell at minimum price to avoid losing sales to rivals (O’Connor, 2004).

The Role of The Government

There is a lot of government intervention in a monopoly to exert control on product pricing, quality, and availability. Government control becomes necessary here owing to the fact that the prices and profits of a monopoly are not influenced by the actions of competing firms.

Interdependent pricing is a common feature in oligopoly as competing firms are forced to match the price charged by their rivals. This market stricture is associated with collusion by competing firms to hike the price. This necessitates is a lot of government intervention here as government attempt to reign over illegal and anticompetitive tendencies by firms.

In monopolistic competition, the pricing decisions by the firms are informed to a large extent by the availability of substitute goods. Owing to the high level of competition, there is little need for government intervention and price is more or less regulated by the market forces (Garcia & Sorolla, 2014).

In perfect competition, the market price is purely determined by the forces of demand and supply and not by the decisions of individual firms. This means that there is little need for government intervention in regulating the price as firms are already under pressure to offer the minimum possible price (Behringer, 2014).

The Effect of International Trade

International trade usually brings differentiated goods between countries. These goods come with features that make them appear markedly different from competing goods. Horizontally differentiated goods are goods that differ slightly among themselves, though have nearly equal prices. Vertically differentiated goods have different physical features and different prices. In both cases, trade is much dependent on demand (Behringer, 2014).

In monopolistic competition, there are several firms with each firm having commanded some market power as a result of product differentiation. Each firm is however predisposed to compete with firms offering close substitutes. International trade increases competition (Garcia & Sorolla, 2014).

In an oligopoly, there are few firms and each firm commands some considerable market power that originates from the presence of few firms and high barriers to entry. This makes it difficult for foreign firms to penetrate such a market. In a monopoly, one firm has market power and it produces a unique product, which has no close substitutes. International trade has the potential of introducing competitors to such a market thus eliminating the monopoly (Behringer, 2014).In perfect competition, the absence of entry barriers means free entry of firms which will drive profits for firms to zero. The firms will continue investing in production efficiencies since they have no room to lower prices (Rodger & MacCulloch, 2015).

Case Study: Electricity Deregulation in Illinois

For a long time, electricity in Illinois has been viewed as a public utility therefore controlled by the government through ComEd. ComEd is the biggest electricity supplier in Illinois. This is a type of natural monopoly where there has been no room for new entrants in the market as a result of government regulations. After gross inefficiencies and price soars in the sector were experienced, there were calls for deregulation. Today more than half of the electricity being used in Illinois comes from alternative power suppliers. More than 75% of non-residential customers and over 90%of large consumers are now saving millions of dollars every year as a result of procuring electricity competitively. From Just one natural monopoly that has reigned in Illinois for many years, there are currently over 30 alternative power utilities in Illinois with competition now driving creativity and innovation. The Objective of this deregulation exercise is to convert the power industry from a monopoly to a perfect competition intended to increase efficiency and price advantage to the consumers (DeVirgilio, 2008).

This has made it available for consumers to access products and services customized to their individual needs, which were not the case when the power industry was a monopoly. Some of these added benefits to consumers include real time power monitoring, online management, customized bills, real time emergency response, and efficient products (DeVirgilio, 2008).

Because of government policies that treated power as a public good whose supply would be coordinated by the government, power monopolies had developed in Illinois and other US states. The government regulations acted as barriers to entry. Further, the failure to contain price hikes had made electricity very expensive. Through deregulation laws, these barriers to entry have now been eliminated and the power industry is now turning into a perfect competition. We call it a perfect competition because there are several firms operating independently from each other but producing one homogenous product, electricity. There is free entry and exit of firms occasioned by few or no barriers to entry and exit. In this new arrangement, ComEd lacks the market power that it enjoyed before which means it has no ability to control the price but they can only take the price offered by the market (DeVirgilio, 2008).

References

Behringer, S. (2014). Network Effects, Spillovers and Market Structure. Manchester School, 82(2), 143-59.  Retrieved from the EBSCOhost database.

DeVirgilio, B. (2008). A discussion of the deregulation of the energy industry in Illinois and its effects on consumers. Loyola Consumer Law Review 19(3): 2008. Retrieved at www.luc.edu/media/…/brian_de_virgilio.pdf

Garcia, J., & Sorolla, V. (2014). Monopolistic Competition and Different Wage Setting Systems. Scottish Journal of Political Economy, 61(1), 48-77. Retrieved from the EBSCOhost database.

Farrell, J., Shapiro, C. (1990). Asset Ownership and Market Structure in Oligopoly. The Rand Journal of Economics. 21(2), 275. Retrieved from the ProQuest database.

O’Connor, D. E. (2004). The basics of economics. Westport, Conn: Greenwood Press.

Redmond, W. (2013). Three Modes of Competition in the Marketplace. American Journal of Economics and Sociology, 72(1), 423-46. Retrieved from the EBSCOhost database.

Rodger, B. R. & MacCulloch, A. (2015). Competition law and policy in the EU and UK. Routledge.

Sukhatme, N. (2014). Regulatory Monopoly and Differential Pricing in the Market for Patents. Washington and Lee Law Review. 71(3), 1855-1922. Retrieved from ProQuest database.