perfect and imperfect competition

8/7/2019 perfect and imperfect competition

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Generally, a perfectly competitive market exists when every participant is a "price taker", andno participant influences the price of the product it buys or sells. Specific characteristics may

include:

y Infinite buyers and sellers Infinite consumers with the willingness andability to buy the product at a certain price, and infinite producers with the

willingness and ability to supply the product at a certain price.y Zero entry and exit barriers It is relatively easy for a business to enter or

exit in a perfectly competitive market.

y Perfect factor mobility - In the long run factors of production are perfectlymobile allowing free long term adjustments to changing market conditions.

y Perfect information - Prices and quality of products are assumed to be knownto all consumers and producers.[1]

y Zero transaction costs - Buyers and sellers incur no costs in making anexchange (perfect mobility).[1]

y Profit maximization - Firms aim to sell where marginal costs meet marginalrevenue, where they generate the most profit.

y Homogeneous products The characteristics of any given market good orservice do not vary across suppliers.y Constant returns to scale - Constant returns to scale ensure that there are

sufficient firms in the industry.[

In economic theory, imperfect competition is the competitive situation in any market wherethe conditions necessary for perfect competition are not satisfied. It is a market structure that

does not meet the conditions of perfect competition.[1]

Forms of imperfect competition include:

y Oligopoly, in which there is a small number of sellers.y Monopolistic competition, in which there are many sellers producing highlydifferentiated goods.y Monopsony, in which there is only one buyer of a good.y Oligopsony, in which there is a small number of buyers.y Information asymmetry when one competitor has the advantage of more or better

information.

Perfect Competition:

y Short Run Price and Output for the Competitive Industry and FirmIn the short run the equilibrium market price is determined by the interaction betweenmarket demand and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price isconstant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A

firm maximises profits when marginal revenue = marginal cost. In the diagram above, theprofit-maximising output is Q1. The firm sells Q1 at price P1. The area shaded is theeconomic (supernormal profit) made in the short run because the ruling market price P1 isgreater than average total cost.

y


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y

y Not all firms make supernormal profits in the short run. Their profits depend on theposition of their short run cost curves. Some firms may be experiencing sub-normal profitsbecause their average total costs exceed the current market price. Other firms may bemaking normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that theruling market price is below the average total cost curve. At the profit maximising level ofoutput, the firm is making an economic loss (or sub-normal profits)


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y The Effects of a change in Market Demandy In the diagram below there has been an increase in market demand (ceteris paribus). This

causes an increase in market price and quantity traded. The firm's average revenue curveshifts up to AR2 (=MR2) and the profit maximising output expands to Q2. Notice that the MCcurve is the firm's supply curve. Higher prices cause an expansion along the supply curve.Following the increase in demand, total profits have increased. An inward shift in market

demand would have the opposite effect. Think also about the effect of a change in market

supply - perhaps arising from a cost-reducing technological innovation available to all firmsin a competitive market.

yy The Long Run Adjustment Process ( EXTRA Just Read up in Case)y If most firms are making abnormal profits in the short run there will be an expansion of the

output of existing firms and we expect to see the entry of new firms into the industry.

Firms are responding to the profit motive and supernormal profits act as a signal for areallocation of resources within the market. The addition of new suppliers causes anoutward shift in the market supply curve. This is shown in the diagram below.

y


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y Making the assumption that the market demand curve remains unchanged, higher marketsupply will reduce the equilibrium market price until the price = long run average cost. Atthis point each firm is making normal profits only. There is no further incentive formovement of firms in and out of the industry and a long-run equilibrium has beenestablished.

y The entry of new firms shifts the market supply curve to MS2 and drives down the marketprice to P2. At the profit-maximising output level Q3 only normal profits are being made.

There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium isestablished.

yy Does perfect competition lead to economic efficiency?y Perfect competition is used as a yardstick to compare with other market structures (such a

monopoly and oligopoly) because it displays high levels of economic efficiency. In both theshort and long run, price is equal to marginal cost (P=MC) and therefore allocativeefficiency is achieved the price that consumers are paying in the market reflects the

factor cost of resources used up in producing / providing the good or service.y Productive efficiency occurs when price is equal to average cost at its minimum point. This

is not achieved in the short run firms can be operating at any point on their short runaverage total cost curve, but productive efficiency is attained in the long run because theprofit maximising output is achieved at a level where average (and marginal) revenue istangential to the average total cost curve. The long run of perfect competition, therefore,exhibits optimal levels of static economic efficiency.

y There is of course another form of economic efficiency dynamic efficiency whichrelates to aspects of market competition such as the rate of innovation in a market, thequality of output provided over time.

Oligopoly

y Oligopoly is a common market form. As a quantitative description of oligopoly, thefour-firm concentration ratio is often utilized. This measure expresses the market

share of the four largest firms in an industry as a percentage. For example, as of fourthquarter 2008, Verizon, AT&T, Sprint Nextel, and T-Mobile together control 89% of

the US cellular phone market.

y Oligopolistic competition can give rise to a wide range of different outcomes. In somesituations, the firms may employ restrictive trade practices (collusion, market sharing


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etc.) to raise prices and restrict production in much the same way as a monopoly.Where there is a formal agreement for such collusion, this is known as a cartel. A

primary example of such a cartel is OPEC which has a profound influence on theinternational price of oil.

y Firms often collude in an attempt to stabilize unstable markets, so as to reduce therisks inherent in these markets for investment and product development.

[citation needed]

There are legal restrictions on such collusion in most countries. There does not haveto be a formal agreement for collusion to take place (although for the act to be illegal

there must be actual communication between companies)for example, in some

industries there may be an acknowledged market leader which informally sets prices

to which other producers respond, known as price leadership.

y In other situations, competition between sellers in an oligopoly can be fierce, withrelatively low prices and high production. This could lead to an efficient outcome

approaching perfect competition. The competition in an oligopoly can be greater than

when there are more firms in an industry if, for example, the firms were only

regionally based and did not compete directly with each other.

y Thus the welfare analysis of oligopolies is sensitive to the parameter values used todefine the market's structure. In particular, the level of dead weight loss is hard to

measure. The study of product differentiation indicates that oligopolies might alsocreate excessive levels of differentiation in order to stifle competition.

(In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of

economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal. In

other words, either people who would have more marginal benefit than marginal cost are not

buying the product, or people who would have more marginal cost than marginal benefit are buying

the product.)

Forms of Oligopoly:

Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate

and agree to restrict output to the monopoly quantity, where price is greater than margical cost,and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, aduopoly trying to maximize profits will produce more than a monopolist but less than a competitiveindustry. Duopolies come from collusion where firms agree to share output and set prices such asin a cartel.

A cartel is a group of companies acting in unison, such as OPEC. If the competing companiescannot agree, then they may end up with the competitive position with profits equal to zero.Cartels are known to restrict output quantities in order to raise prices, and consequently profits.

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it.As the number of companies increases, the more the industry resembles a competitive outcome,since each company has a smaller effect on the outcome. The mentality where each companytends to think only of its own profits and strategic behaviour is reduced. Each company willincrease production as long as price is greater than marginal cost. As the number of companiesincreases, we tend to move towards a perfectly competitive outcome.

Game Theory and Prisoners' Dilemma


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Game theory is the study of how people behave in strategic situations (i.e. when they mustconsider the effect of other peoples responses to their own actions). In an oligopoly, eachcompany knows that its profits depend on actions of other firms. This gives rise to the "prisonersdilemma".

The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, evenwhen it is in the best interest of both parties. Both players select their own dominant strategies for

shortsighted personal gain. Eventually, they reach an equilibrium in which they are both worse offthan they would have been, if they could both agree to select an alternative (non-dominant)strategy.

While the economy is becoming more global, some factions in developing countries are against themerging of markets. This has lead to violence in some parts of the world. Ambassadors and otherofficials traveling to foreign nations are normally supplied with body armor and a convoy forprotection against hostile groups.

Firms involved in oligopoly should be aware of price leadership. Price leadership has

two models.

Low Cost Firm

First one is price leadership of a low cost firm, which sets price according to its low

costs. And other firms in that industry follow it to prevent price wars because they

realize that they will lose their customers attracted to the lowest price set by the low cost

firm.

Everyone wants to be the price leader. All the firms indulge in cost cutting through

various means. For example, through technology upgradation TOI hit Indian Express

through launch of Mumbai Mirror.

However, the low costs are a temporary phenomenon. They are customer friendly

initially but as soon as the market niche is created, prices change.

Dominant Firm

In some markets there is a single firm that controls a dominant share of the market and

a group of smaller firms. The dominant firm sets prices which are simply taken by the

smaller firms in determining their profit maximizing levels of production. This type of

market is practically a monopoly and an attached perfectly competitive market in which

price is set by the dominant firm rather than the market. The demand curve for the

dominant firm is determined by subtracting the supply curves of all the small firms from

the industry demand curve. After estimating its net demand curve (market demand less

the supply curve of the small firms) the dominant firm maximizes profits by following the

normal p-max rule of producing where marginal revenue equals marginal costs. The

small firms maximize profits by acting as PC firms - equating price to marginal costs.

-in brief( Ans 5 sent by shirish_)

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perfect and imperfect competition