Market Structure

Market Structure

Meaning

• Market structure is one of the commonly used approaches to study the behaviour of firms in an economy.

• The type of decisions a firm makes and the potential of the firm to earn profits in the long- run depends on the type of market structure in which the firm operates.

Forms of Market

• Market structure can be broadly divided into two categories : –

1. Perfect Competition

2. Imperfect Competition.

Perfect competition• Meaning : A perfectly competitive market is defined as a market in

which no individual firm can influence the market price on its own.• There are a large number of buyers and sellers selling homogenous

products; a single buyer or seller cannot influence the price of a product.

• In this type of market price is determined by the industry, i.e., all the firms taken together. The individual firm is called as “price taker”.

• Although perfect competition does not exist in the real economy it is helpful for managers and business persons to take decisions regarding an ideal combination of output-pricing for an industry or a firm. It also helps in analyzing the role of demand and supply in price determination.

Imperfect competition• An imperfect market can be defined as a market with many

producers offering goods which are close substitutes, but not identical as in the case in perfect competition .Since the products vary in their features, the pricing also varies.

• Under imperfect competition comes monopoly, monopolistic competition and oligopoly.

• In a monopoly, there is only a single seller controlling the entire market .It is a market situation in which there is only one firm producing a good.

• Oligopoly can be defined as a market structure in which there are a few sellers in the market. They produce either homogeneous products or products which are close but not perfect substitutes for each other.

• In monopolistic competition, there are a number of sellers and buyers trying to differentiate the market through product differentiation and price discrimination.

How do sellers try to differentiate their products under imperfect

competition?Mainly on the basis of the following 4 aspects:

1. Physical Features - Size,weight,color,taste,texture,design,particular attributes,etc.

2. Location – The number and variety of locations where a product is available.

3. Services – Products can be differentiated on the basis of the services that accompany them. For instance, some retail outlets have sales staff who help you choose things, while others don’t.

4. Product Image – The image that the producer tries to build up in the consumer’s mind through packaging, etc. For example, some shampoos are sold only in salons.

Characteristics/Features of a Perfectly Competitive Market

1. Large number of buyers and sellers-This means the individual buyer or seller is an insignificant player in the market.

2. All firms produce homogeneous (identical) products. The products are identical in terms of quality, variety, color, design, packing and other selling conditions of the market.

3.There is perfect knowledge about market and technology – This means that all producers and consumers are fully informed about the market. No body is ignorant.

4.Freedom of entry and exit of firms- There are no obstacles in the way of new firms joining the industry and existing firms leaving the industry.

• This ensures that there are neither above normal profits nor losses by any firm in the long run.

• In the short run profits and losses are possible because during this period firms are not in a position to enter or leave the industry.

• If firms are making profits, new firms enter and raise the total supply of the industry. This reduces market price and eventually wipes out profits.

• If firms are incurring losses, the existing firms start leaving the industry and reduce the total supply. This raises the price till all the losses are wiped out.

• The above condition amounts to perfect mobility of resources into and out of industry.

• Absence of transportation cost

Features of Monopoly

1. A single seller - Monopoly is a type of market structure in which there is only one producer of the product in the market.

• It may be due to some natural conditions prevailing in the market, or may be due to some legal restriction with regard to patent copyright, sole leadership, state monopoly ( electricity,water supply,etc.)

• Since there is only one seller, any change in supply plans of that seller can have substantial influence over the market price. This is why a monopolist is sometimes called a price maker.

2. No close substitute : A product faces competition from its substitutes. A good may have many substitutes. But not all substitutes offer competition.

• The substitutes which are too costly and inconvenient do not offer any competition. Such can be called ‘distant substitutes’.

• The substitutes which can be conveniently used in place of the given product and are available at a near about price do offer competition. These may be called ‘close substitutes’. A monopoly has no such close substitutes and ,therefore, practically does not face any competition.

3.No freedom of entry: There is no freedom for the new firms to enter the industry. It may be due to some government order. For example, production of many defence goods is monopoly of the government due to national security consideration.

• Similarly, production of some public utility goods is also monopoly of states in India, for example, electricity, water supply etc. These are called as State Monopolies.

• Another reason behind denial of freedom is patent laws. Those who develop new products are granted patent rights. Only the producer who has been given the patent right is legally allowed to produce that product.

• It is indeed very difficult to enjoy monopoly. A company may want to exist as monopoly-then, it has to create some barriers to entry for its competitors.

• These barriers can be in the form of economies of scale, product differentiation ,low costs or ownership and control over the key factors of production.

Price discrimination• In practice, it is difficult for firms to charge

different prices for different units of the same good.

• However, this practice is adopted by the state electricity boards whose per unit rate increases as the number of units of power consumed increases.

• In general, it is easier for a monopolist to classify customers into different groups with different elasticities of demand.

Is it easier for a monopolist to classify customers into different groups with

different elasticities of demand? How?

• When the monopolist charges different prices from different buyers for the same good, he is known as a ‘discriminating monopolist’.

• Price discrimination is quite possible in monopoly. A monopolist ,however can charge different prices for the same good.

• There are 2 conditions which must be fulfilled for price discrimination to be possible.

• Firstly, the market must be divided into submarkets with different price elasticities.

• Secondly, there has to be an effective separation of the submarkets, so that no reselling takes place from a low-price market to a high-price market. Airline industry should be considered as the perfect example for this.

Price discrimination is made possible, by 3 factors

1. Consumer’s preferences

2. The nature of the good

3. Distance and frontier barriers

Consumer’s preferences• When consumer A is unaware of the fact that

consumer B gets the same good at a different price.

• When the consumer has an irrational feeling that he is paying a higher price for better quality, though ,in reality, it may not be true.

• When the price differences are so minute that the consumer is not worried about it.

The nature of the good

• Since the resale of certain direct services is not possible, these provide enough opportunities for price discrimination ; example : the service of a doctor.

Distance and frontier barriers• Price discrimination is also possible due to

distance and frontier barriers.• For example, when the monopolist is serving

two markets :a home market where there is a tariff (a tax imposed on an imported good) and a world market where there is no tariff, he can take advantage of the protected market (where there is tariff ) and charge a higher price in the home market.

• Price discrimination may also take place due to differences in the transport costs.

Types of Price Discrimination

• First – degree price discrimination

• Second-degree price discrimination

• Third-degree price discrimination

First-degree discrimination• This is the most extreme form of

discrimination in which each consumer is charged the maximum price he would be willing to pay for each individual unit consumed.

• For the firm this is the most profitable pricing scheme. Because the buyers are charged the maximum possible price for each unit of output, there is no consumer surplus.

• Consumer surplus can be defined as the difference between what they would like to pay for a product and what they actually pay.

• The seller should have complete knowledge of the market demand curve and also of the price individual would be willing to pay for the product.

• Sometimes, this type of discrimination is seen in the healthcare industry where doctors charge different fees from different patients.

Second-degree Price Discrimination

• This is a more practical form of price discrimination. Here, firms charge a different price for each set of units sold.

• Different prices are charged for different blocks or portions of consumption. This is an imperfect form of price discrimination.

• Instead of setting different prices for each unit, the prices are based on the quantities of output purchased by individual consumers.

• In most cases, second-degree price discrimination is seen in utilities like power and telecom.

Third-degree Price discrimination

• This is the most common form of price discrimination . Consumers or markets are segmented on the basis of their price elasticity of demand.

• Often, third-degree price discrimination occurs in the markets that are geographically separated.

• Let us consider an example. Books published by American publishers are sold in other countries at a lower price than in the US.

• Evidently, buyers in other countries have greater elasticities of demand than US buyers.

• At the same time, the high shipping costs makes it unprofitable for firms to buy in foreign countries and resell in the United states.

How monopolies can prevent competition?

• Monopolies will try to prevent new firms from entering their market and taking a share of their profits by creating barriers to entry.

• There are 2 types of barriers to entry.1. Natural barriers2. Artificial barriers

Natural barriers to entry

• Some firms naturally become monopolies because of the following:

• Control of supply – Some firms may own most of the supply of a raw material.

• Economies of scale – There may be cost savings being gained from increasing production. This further leads to natural monopoly as the large firm is able to sell at a reasonable price than a number of smaller firms.

• Due to huge expense – Some industries, for example, Nuclear Power Industry, need many millions worth of equipment.

• Legal considerations – Some firms can stay as monopolies because laws have been passed accordingly .This can happen when a firm invents a new product or method of production and prevents other firms from copying it by a patent.

Artificial barriers to entry

• While some monopolies occur as a result of natural barriers to entry, other monopolies achieve their powerful position by creating their own artificial barriers to competition.

• Companies can create artificial barriers to entry to new firms who are potential competitors.

• Restrictions on supplies : New firms will only enter an industry if they can obtain supplies of raw materials. Monopoly firms can threaten their suppliers that if they supply any new firms, the monopoly will take its custom to another supplier.

• Predatory Pricing : Often monopolies are very profitable and sell a wide range of goods and services. New small companies attempting to compete with large monopolies will not be as profitable and are unlikely to be able to sell such a wide range of commodities.

• Predatory pricing occurs when a large firm cuts its prices, even if this means losing money in the short run, in order to force new and smaller competing firms out of business.

• Once the smaller firm has been removed, the larger firm can raise its price again.

• Exclusive dealing : Businesses that sell the products made by a monopolist rely heavily upon the monopolist for supplies.

• If the monopolist produces a well-known and popular good or service it gives them the power to threaten the firms selling its products.

• Refusing to sell to shops that stock other firms’ brands of a similar product is known as exclusive dealing.

Monopolistic Competition• This market structure is a combination of elements

from Perfect competition and Monopoly.

• Monopolistic competition resembles perfect competition to a large extent, the only exception being that there is a certain amount of Product differentiation.

• All the producers here are monopolists in their own product markets. However, as most of these products have close substitutes, the demand curves are considerably elastic.

Features

• Large number of sellers and buyers.• Firms produce differentiated products.• Firms have perfect knowledge about market

and technology.• Free entry and exit of firms

Product differentiation

• Let us look at the way monopolistic competition works with the help of an example, say the shampoo industry in India.

• Various manufacturers produce different brands such as Sunsilk, Pantene,Head & Shoulders etc.

• The manufacturer of Sunsilk has a monopoly over the brand,and no other producer can produce and use Sunsilk brand name.

Product differentiation contd..

• But the producer of Sunsilk faces tough competition from the other shampoo producers.

• The manufacturer of Sunsilk cannot decide the price of the product without considering the prices for other shampoos in the market,which are close substitutes.

Product differentiation can be done on the basis of two factors

• First, products can be differentiated on the basis of certain characteristics of the product such as exclusive patented features, trademarks and some special type of packages or wrappers .

• Second, based on the conditions surrounding the sale of the product and after sales service. The product is differentiated if the after sales services rendered by the firm are different from those of other firms in the market.

• Marketers in monopolistic competition resort to product differentiation in order to maximize profits.

• Many companies try to differentiate the same product by adopting the various techniques of branding.

• Companies use brand extensions-for example Clinic Plus Shampoo, Clinic All Clear ,Clinic Plus Hair Oil etc to differentiate the products.(umbrella strategy)

• HLL follows an individual branding strategy and has several brands in the same category such as Lux ,Liril, Rexona soaps etc.

• Competitor of HLL may differ in selection of strategy .They follow umbrella branding strategy.

• Firms in service industry also try to differentiate themselves through their logos. A logo could be just another picture, or could become an identity of the organization.

• Service companies such as banks, financial companies, insurance companies, consultancies and airlines try to create an association in the customers mind with the help of the logo.

• Thus logo gives a distinct personality to the organization.

Types of product differentiation

• Product differentiation can be in two forms:• Real or fancied.• It is real when the inherent characteristics of

the product are different .• It is fancied when the products are basically

the same.

Real product differentiation

• It takes place when there are differences in product specifications or differences in location of the firm which determines whether the product is available conveniently to the potential customers.

Fancied product differentiation

• When the product is differentiated through advertisement, difference in packaging, design or brand name then it can be called fancied product differentiation.

Oligopoly and its features• It is a form of imperfect competition in which

a few firms produce either homogeneous products which are close but not perfect substitutes for each other.

• This is a market structure which has a small number of large producers.

• The number of firms may vary from two to ten.

• A market in which there are only two players is called a Duopoly.

• Oligopolies are interdependent in their decision making.

• Barriers to entry protect these firms from outside competition.

• Economies of scale could be one factor limiting the market to a few sellers.

• They know their rivals pretty well and keep a close watch on their actions while formulating their own strategies.

• Pricing decisions depends on the demand conditions, the cost conditions and the pricing strategies of competitors.

• In an oligopoly market, it is difficult to determine the equilibrium price and output because there is interdependence among different firms and it is difficult to specify the particular reaction of the rivals.

Oligopolies may be classified as collusive and non collusive oligopolies.

• In collusive oligopoly, firms cooperate with one another and jointly set their prices or outputs.

• They divide the market among themselves and also make other business decisions jointly.

• In non collusive oligopoly, firms compete with one another and make pricing decisions independently.

• Barriers to enter in an oligopolistic market is usually high.

• Barriers may be either natural or deliberately created.

Cartel Formation

• Cartels are formed when competing oligopolists enter into some kind of an agreement in order to maximize joint profits.

• Cartels aiming at the sharing of the market is another type.

• The firms appoint a central agency. This agency is delegated the authority to decide not only the total quantity and the price but also the allocation of production among the members of the cartel and the distribution of the maximum joint profits among them.

• The central agency has complete information about the cost functions of the members. It is assumed that all members produce identical products.

• Limitations: Though theoretically the cartel can maximize joint profits, in practice this is not always possible. There are several reasons for this.

• Mistakes may occur in estimating market demand, marginal costs. The existence of high-cost firms may become an obstacle for a cartel.

• Some times a cartel refrains from maximizing total profit ,for fear of government intervention or fear that other firms may enter the market.

• Sometimes a cartel may not maximize total profit in order to maintain a good public image.

Price Leadership

• It is another form of collusion in an oligopoly market. One firm sets the price and the other firm follow it, because it is advantageous to them or they prefer to avoid uncertainty.

• The most common types are:• Price leadership by a low-cost firm• Price leadership by a large (dominant) firm• Barometric price leadership( it is a firm which has

established the reputation of being a good forecaster of economic changes. Note: It need not always belong to the same industry).

Game Theory• Game theory was developed by an economist,

Oskar Morgenstern, and a mathematician, John von Neumann, in the 1950’s.

• The outcome of incomes for the players in the game theory is represented in a pay-off matrix.

• The various strategies which the players can adopt are:

• The dominant strategy,• The Nash equilibrium strategy and• The maxi-min strategy.

• All these strategies provide an insight into the significance of game theory in guiding the business behaviour.

• In a market situation of imperfect competition, specifically when oligopoly prevails ,each firm operating in the market can influence the prices of goods even when the goods are homogeneous.

• Managers of firms need to make business decisions while considering the moves by other competing firms in the market.

• Analyzing the competitor’s moves and making decisions to maximize profits for the firm is facilitated by the use of game theory.

• A ‘game’ is a situation in which the decisions of one player are interdependent on the decisions of other rival players.

• It is technique which helps in evaluating a situation when different individuals or organizations differ in their objectives.

Outcomes/Pay-off matrix

• To understand the basic concepts of game theory, let us analyze a duopoly price war.

• Duopoly is a market where only 2 players supply products to the same market.

• In an industry where 2 firms, X and Y, are operating, there are 4 different outcomes based on the strategies adopted by each firm.

• There is a possibility for each firm to operate at normal prices or to cut prices in order to gain the market share.

• The 4 possible combinations of strategies are:1. Both firm X and firm Y operate at normal

prices.2. Firm X cuts the price but firm Y maintains

normal price.3. Firm X maintains normal price and firm Y cuts

the prices.4. Both the firms cuts the prices.

The Pay-off Matrix

FIRM X FIRM X

NORMAL PRICE

COMPETITION PRICE

FIRM YNORMAL PRICE

P ( 100,100) Q (-500,-100)

FIRM Y COMPETITION PRICE

R (-100,-500) S (-300,-300)

• As per the pay-off matrix given here, both firms have profits as in cell ‘P’ when they operate at normal prices.

• Both firms get losses as in cell ‘S’ if both decreases the prices.

• There is difference in the pay-offs as represented in the cells ‘Q’ and ‘R’ when only one of the firms cuts the price and the other operates at normal price.

Dominant Strategy

• The dominant strategy is the strategy, which is profitable for one of the players, irrespective of the strategy adopted by the other player.

• From the pay-off matrix we can learn when the firm X operates with normal price, it gets Rs.100 only if firm Y also operates with normal price.

• If firm X gets into price war and cuts the prices but firm Y still maintains normal prices then the firm X will lose Rs.500.

• This is because even if firm X gains market share due to price cut, it has to sell the products at a price lower than the cost of manufacturing.

• Similarly, if firm Y cuts the prices, but firm x maintains normal prices then the loss for firm X is Rs.100.

• If firm X enters the price war along with firm Y, then the loss is Rs.300 for firm X.

• Thus, firm X and Y also experience greater losses when they cut the price but the other firms operate at normal price.

• Hence, each firm can benefit by operating at normal price irrespective of the type of price strategy followed by the other firm.

Nash equilibrium

• Nash equilibrium was named after John Nash, a mathematician, who contributed to the game theory and also won the Nobel prize in economics.

• In the real world, the applicability of dominant strategy is limited. When there is no dominant strategy applicable, each of the firms considers operating at normal prices or increases and try to earn monopoly profits.

• At the Nash equilibrium, the pay-off of no player can be improved at a given strategy of the other player.

• That is, the strategy of each player is a best response to the strategy of the other player and each player chooses a strategy which is most beneficial to it.

• This explains the basic rule of game theory, that the strategy of each player should be based on the assumption that the other player will choose a strategy that is best for itself.

Maxi-min strategy

• The developers of game theory further suggested that if the players are risk averse, they will try to maximize the minimum possible benefit from the game.

• With maxi-min strategy, each player tries to get the maximum profit in the worst possible outcome at whatever strategy adopted by the other competing players.

Assumptions of game theory

• Each player is aware of the strategies available to himself and also for competitors.

• All the players in the game are intelligent and rational.

• Selection of strategies by players is simultaneous.

• Players try maximize gain or minimize loss and may work out a collusion to achieve objectives.

Setbacks of game theory• The players can only make a guess about the

rivals’ strategies and the reaction of competitors is not certain.

• In practice, the game theory analysis is complex and difficult as there are strong firms operating in an oligopoly situation.

• Collusion between players to maximize profits is impractical, even if it takes place it would not last long.

• However, game theory provides useful insight into the operations of oligopoly markets.