This is the most competitive market structure. A number of conditions need to be fulfilled before perfect competition is said to exist. These conditions are as follows:
Price determination in perfect competition
Firms need to cover costs of production and to earn a certain level of profits in order to stay in business. This minimum level of profits is called ‘normal profit’,and profits over and above this level are called ‘abnormal profits’. If the firm is trying to maximize its profits it will decide what level of output to produce by setting the cost of producing the last unit of the good equal to the revenue gained from selling the last unit: in economic terminology, where marginal cost equals marginal revenue. Included in cost would be elements of wages, rent, rates, interest, raw materials and normal profits. If these costs are not being covered the firm will be making a loss.As there is only one price in perfect competition, the revenue derived from selling the last unit must be equal to its price. Therefore, the price of the good depends on the level of marginal cost.In the short run, individual firms can earn abnormal profits, but these are not sustainable in the longer term. If one firm is earning abnormal profits, given the assumption of perfect knowledge, everyone will know and, since freedom of entry exists, other firms will enter the market in order to earn abnormal profits. This means that there is an increase in market supply and price will fall back to a level where abnormal profits have been competed away. Similarly when losses are being made, freedom of exit means that supply will be reduced and price will rise again until normal profits have been regained.The implications of perfect competition for market behaviour and performance are summarized in Table. Perfect competition involves very restrictive assumptions, which will rarely be fulfilled in the real world. The usefulness of the model lies in its role as an ideal market in which competition is at a maximum, rather than in its applicability to the real world.
An example of perfect competition?
The nearest example to perfect competition is probably the fruit and vegetable market in the center of a large town. The goods will be fairly homogeneous, with perhaps slight variation in the quality. Knowledge will be almost perfect with respect to prices charged, as consumers could quickly walk around the market and ascertain the price of tomatoes, for example. Mobility of consumers is also high because the sellers are located in the same place. Thus the conditions for perfect competition nearly hold. The prediction is that there will be only one price for a particular good. Again this prediction is nearly fulfilled; the price of tomatoes tends to be rather similar across such a market, and when one trader reduces the price towards the end of the day, others tend to follow suit. Another market which is said to be close to perfect competition is the stock exchange, although with the increasing use of computers this is less likely to be true in the future.
Monopoly lies at the opposite end of the spectrum to competition. In its purest form a monopolistic market is one in which there is no competition at all; there is a single producer supplying the whole market. The monopolist has considerable market power and can determine price or quantity sold, but not both because he or she cannot control demand. The power of the monopolist depends on the availability of substitutes, and on the existence and height of barriers to entry. If there are no close substitutes for the good being produced, or if there are high barriers to entry, the power of the monopolist will be high and abnormal profits can be earned in the long run.
A monopolist could also be a group of producers acting together to control supply to the market: for example, a cartel such as OPEC (Organisation of Petroleum Exporting Countries). In monopolistic markets the producer might be able to charge different prices for the same good: for example, on an aeroplane it is quite likely that there will be passengers sitting in the same class of seat having paid very different prices, depending upon where and when the tickets were bought. Essentially they are paying different prices for the same service, and the producer is said to be exercising price discrimination.
Why is this possible? There are certain conditions that must hold for this type of price discrimination to occur. First, the market must be monopolistic and the producer must be able to control supply. Second, there must be groups of consumers with different demand conditions. For example, the demand for train travel by the commuter who works in London will be more in elastic than the demand of a student going to London for the day, who could use alternative forms of transport or even not go. This means that the willingness to pay among consumers will vary.
The final condition necessary is that it must be possible to separate these groups in some way. For example, telephone companies are able to separate markets by time so that it is cheaper to phone after a certain time; British Rail used to separate groups by age for certain of its rail cards.The monopolist will maximize its profits by charging different prices in different markets. Price discrimination is often thought of as a bad thing as the monopolist is exploiting the consumer by charging different prices for the same good. But there are some advantages, in that it makes for better use of resources if cheap airline tickets are offered to fill an aeroplane which would otherwise have flown half-full.It can also lead to a more equitable solution in that higher-income users pay a higher price than lower-income users. The main problems with the notion of price discrimination is not that it is always a bad thing, but that it is the monopolist who has the power to decide who is charged what price.Again the effects of monopoly on the behaviour and performance of the firm can be predicted. Like perfect competition, this is a highly theoretical model and is mainly used as a comparison with perfect competition to show the effects of the lack of competition.
A comparison of perfect competition and monopoly
There is less incentive to innovate under monopoly, since the monopolist is subject to less competition. But, equally, a monopolist might have more incentive to innovate as it can reap the benefits in terms of higher profits. It may also have more resources to devote to innovation.
As can be seen there is not a clear set of arguments that imply that perfect competition is better than monopoly, this is taken into account in UK competition policy.
An example of monopoly?
Although it is easy to think of examples of industries where the dominant firm has a great deal of monopoly power, there is no such thing as a pure monopoly, as substitutes exist for most goods. For example, British Rail used to have monopoly power in the market for rail travel, but there are many alternative forms of travel.
This point highlights the difficulties of defining markets and industries discussed. The nearest examples of monopolies are the old public utilities, like gas, electricity, water and so on, many of which have been privatized.
The government, in determining whether monopoly power exists in a market, has a working definition of what constitutes a monopoly. It is when 25 per cent of the market is accounted for by one firm or firms acting together. This would form grounds for investigation by the Competition Commission. The process of UK competition policy is discussed in Chapter in more detail. The sources of monopoly power are the existence of barriers to entry and exit and the availability of substitutes(these will be discussed later in this chapter).
In both perfect competition and monopoly firms make independent decisions. In the case of monopoly there are no other firms in the industry to consider; in the case of perfect competition the firm has no power to affect the market at all. So for different reasons they act as though they have no rivals. This is not true in the case of oligopoly. Oligopoly is where a small number of producers supply a market in which the product is differentiated in some way. The characteristics of oligopoly are:
Compared with monopoly and perfect competition, oligopoly is a much more realistic market structure, with many markets exhibiting the characteristics stated above.
A market structure of monopolistic competition exists when all of the conditions for perfect competition are met except for the existence of a homogeneous good, so that each firm has a monopoly over its own good but there is a great deal of competition in the market from other suppliers producing very similar products. In monopolistic competition the good is slightly differentiated in some way, either by advertising and branding or by local production. There does not have to be a technical difference between the two goods, which could be identical in composition, but there must be an ‘economic difference’ that is, a difference in the way the goods are perceived by consumers. There is also some degree of consumer loyalty, so that if one firm reduces price, consumers might not necessarily move to that firm if they believe that the difference between the brands justifies the higher price.
Abnormal profits can exist in the short run but cannot persist since new firms are free to enter the industry and compete away abnormal profit.An example of monopolistic competition?
There are many examples of this type of industry: for example, the paint industry where ICI is the only producer of Dulux but there are many other types of paint on the market.
How accurate is the theory?
The implications of the theory of market structures for the behaviour and performance of firms are summarized in Table. As argued above, both perfect competition and pure monopoly tend to be based on assumptions that are somewhat unrealistic and should be regarded as ‘ideal types’ of market structure, in the sense that they establish the boundaries within which true markets exist and operate, and against which they can be analysed. In contrast, oligopoly and monopolistic competition are much nearer to the types of market structure which can be found in the real world, and economic theory does appear to explain and predict behaviour in these markets to a certain extent. In oligopolistic markets, for example, price tends to be ‘sticky’ and much of the competition between firms occurs in non-price ways, particularly branding, advertising and sales promotion. Occasionally, however, price wars do occur as in the petrol market in the 1980s and more recently between the four biggest supermarkets.
Table shows the top advertisers in the United Kingdom ranked for 2003; their ranks in 1995 are also given. The names in the list are familiar and largely expected from the predictions: for example, Procter & Gamble is one of the twocompanies which together with Unilever account for around 90 per cent of the market for washing powder. It is much more difficult to judge how accurate the behavioural implications are,
Lack of data is one problem, as is the fact that only one structural characteristic has been considered here the level of competition between producers. The other structural factors listed in Table will also have an effect, like the level of demand, the degree of competition between the buyers and the degree of potential competition. Profitability, price and advertising, for instance, will be affected by the level of demand in the market.
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Business Organisations: The External Environment
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The Political Environment
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The Demographic Environment Of Business
The Resource Context
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Size Structure Of Firms
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The Market System
International Markets And Globalization
Governments And Markets
The Technological Environment: E-business
Corporate Responsibility And The Environment
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