Managerial Economics (chapter 8)

Market Structure: Perfect Competition, Monopoly, Oligopoly and Monopolistic Competition Instructor: Maharouf Oyolola

Introduction • In this chapter we are mostly interested in how price and output are determined under different market structure. Thus, we will study how price and output are determined under perfect competition, Monopoly, Oligopoly and Monopolistic Competition.

The Market concept • A market is a group of economic agents (individuals and/or firms) that interact with each other in a buyer-seller relationship. • This interaction results in transactions between the demand (buyer) side and the supply (seller) side of the market.

Market structure and Degree of competition • The process by which price and output depends heavily the structure of the market. • Four types of market structure are usually identified: Perfect Competition, Monopoly, Oligopoly and Monopolistic Competition.

Characteristics of a Perfectly Competitive market 1

2 3

) A very large number of buyers and sellers → each of them buys or sells such a small proportion of the total industry output that a single buyer’s or seller’s actions cannot have an impact on the market price. ) A homogenous product produced by each firm, that is, no product differentiation. )Free entry and exit from the market, that is minimal barrier to entry and exit

Characteristics of a Perfectly Competitive market • 4) No collusion among firms in the industry • 5) Complete knowledge of all relevant market information by each firm. • Note: A firm operating within a perfectly competitive industry is a price-taker.

Characteristics of a monopolistic market • 1) only one firm produces the product • 2) Low cross elasticity of demand between the monopolist’s product and any other product; that is no close substitute products. • 3) Substantial barriers to entry that prevents competition from entering the industry.

Characteristics of a monopolistic market • These barriers include the following: • - large capital requirements, exceeding the financial resources of potential entrants. • - Legal exclusion of potential competitors • - Absolute cost advantages of the established firm

Characteristics of a monopolistic competitive market • 1) Large number of firms • 2) Product differentiation. Each firm is selling a product that is differentiated in some manner. • 3) No collusion among firms in the industry • 4) Free entry and Exit • Note: By far the most distinguishing characteristic of monopolistic competition is that the outputs of each firm are differentiated in some way from those of every other firm. In other words, the cross-elasticity of demand between the products of individual firms is high.

• Product Differentiation may be based on certain characteristics of the product itself, such as trade names; quality, design, color or style.

Characteristics of an oligopolistic market • 1) Small number of firms • 2) Interdependence of firms • 3) The products that are produced by oligopolists may be homogenous – as in the cases of basic steel, aluminum, and cement – or differentiated- as in the cases of automobiles, cigarettes, home appliances, soaps, detergents, and air travel.

Price determination under perfect competition P

QD

QS

55

350

450

45

400

400

35

450

350

25

500

300

15

550

250

Determine the equilibrium price and quantity algebraically • • • • •

QD=625-25P QS=175+15P Setting QD=QS P=$45 QD=400

• Page327 and 328

Competition in the global economy • In this section we examine how international competition affects prices in the nation, how the value of the nation’s currency affects the nation’s international competitiveness, and how a competitive firm in the nation adjusts to international competition.

Domestic Demand and Supply, Imports, and Prices • Domestic firms in most industries face a great deal of competition from abroad. Most Us-made goods today compete with similar goods from abroad and vice-versa. • Examples of industries in which domestic firms compete with foreign firms: Steel, automobile, television sets, cameras, wines, computers and aircrafts.

See figure 8-4 page 335 • In figure 8-4, DX and SX refer to domestic market demand and supply curves of commodity X. • In the absence of trade, the equilibrium price is given by the intersection of DX and SX at point E, so that domestic consumers purchase 400X (all of which are produced domestically) at PX=$5

See figure 8-4 page 335 • With free trade at the world price of PX=$3, the price of commodity X to domestic consumers will fall to the world price. • The foreign supply curve of this nation’s imports, SF, is horizontal at PX=$3 on the assumption that this nation’s demand for imports is very small in relation to the foreign supply. From the figure, we can see that domestic consumers will purchase AC or 600X at PX=$3 with free trade (no transportation costs), as compared with 400X at PX=$5 in the absence of trade (given by point E.

See figure 8-4 page 335 • Figure 8-4 also shows that with free trade, domestic firms produce only AB or 200X, so that BC or 400X is imported at PX=$3. Resources in the nation will then shift from the production of commodity X to the production of other commodities in which the nation is relatively more efficient or has a comparative advantage.

See figure 8-4 page 335 • With tariffs or other trade restrictions, the price of commodity X in the nation will be higher than the free-trade price of $3, and the nation’s imports will be smaller than 400X. • However, tariffs and other restrictions to the flow of international trade have been reduced sharply over the past decades and have been all eliminated for trade among 15-nation European Union (EU) and in North America ( NAFTA)

The Dollar Exchange Rate and the International Competitiveness of U.S. Firms • The Foreign Exchange market is the market where one currency is exchanged for another. • The foreign exchange market for any currency, say the US dollar, is formed by all the locations (such as London, Tokyo, and Frankfurt, as well as New York) where dollars are bought and sold for other currencies. • These international monetary centers are connected by a telephone and telex network and are in constant contact with one another.

• The exchange rate is the rate at which one currency is exchanged for another. • This is the price of a unit of the foreign currency in terms of the domestic currency. For example, the exchange rate (R) between the US dollar and the euro (€) , the currency of 12 nations of the European Monetary Union (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain) is the number of dollars required to purchase one euro.

Example • If R =$/€=1, the means that one dollar is required to purchase one euro. • Under a flexible exchange rate system of the type we have today, the dollar price of the euro (R) is determined (just like the price of other commodity in a competitive market) by the intersection of the market demand and supply curves of euros.

See figure 8-5 page 337 • The vertical axis measures the dollar price of euros, or the exchange rate ( R=$/€) , and the horizontal axis measures the quantity of euros. • The market demand and supply curves for euros intersect at point E, defining the equilibrium exchange of R=1, at which the quantity of euros demanded and the quantity of euros supplied are equal at €300 million per day.

See figure 8-5 page 337 • At a higher exchange rate, the quantity of euros supplied exceeds the quantity demanded, and the exchange rate will fall toward the equilibrium rate of R=1. • At an exchange rate lower than R=1, the quantity of euros demanded exceeds the quantity supplied, and the exchange rate will bid up toward the equilibrium rate of R=1.

See figure 8-5 page 337 • The lower is the exchange rate (R) , the greater is the quantity of euros demanded by the United States.→ the lower the exchange rate, the cheaper it is for the United States to import from and invest in the European Monetary Union (EMU), and thus the greater is the quantity of euros demanded by US residents.

• If the US demand curve for euros shifted up as (e.g., as a result of increased US tastes for EMU’s goods) and intersected the US supply curve for euros at point A, the equilibrium exchange rate would be R=1.10, and the equilibrium quantity would be €400 million per day. The dollar is then said to have depreciated, since it now requires $1.10 (instead of the previous $1.00) to purchase one euro.

• Depreciation refers to an increase in the domestic price of the foreign currency. • Appreciation refers to a decline in the domestic price of the foreign currency. • In the absence of interferences by national monetary authorities, the foreign exchange market operates just like any other competitive market, with the equilibrium price and quantity of the foreign determined at the intersection of the market demand and supply curves for the foreign currency.