FORMS OF MARKET AND PRICE DETERMINATION

AGE 525

(MICROECONOMICS IN AGRICULTURE)

MEANING OF MARKET

• In general, the word ‘market’ refers to a place or an area where buyers and sellers generally meet so as to buy and sell a particular commodity.

• In Economics, we make use of the term ‘market’ in a different sense. It refers to a particular commodity that is sold and purchased rather than a place or an area.

• For example, cotton market, tea market etc. Any effective arrangement for bringing buyers and sellers into contact with one another is defined as a market in economics.

The essentials of a market are the following:

1. Market does not confine to a particular place but the whole area wherein buyers and sellers of a commodity are spread over;

2. There must be buyers and sellers and for that physical presence is not necessary. In modern days, we sell goods through websites or electronic shopping markets or through telephonic media;

3. There must be a commodity which is bought and sold; and

4. There should be free interaction between buyers and sellers so that only one price is agreed upon for the commodity.

FORMS OF MARKET

Economists have classified markets on the basis of:

(a) the number of buyers and sellers of the commodity;

(b) the nature of the commodity produced by the sellers;

(c) degree of freedom in the movement of goods and factors; and

(d) whether knowledge on the part of the buyers and sellers regarding prices in the market is perfect or imperfect.

FORMS OF MARKET

On the basis of these criteria, economists have distinguished between four basic forms of the market:

1. Perfect competition

2. Monopoly

3. Monopolistic competition

4. Oligopoly

PERFECT COMPETITION A market is said to be perfect when there is a large number of buyers and sellers of the product and there is a complete absence of rivalry among the firms. The firms sell products which are homogeneous.

Features of Perfect Competition

The important features of this type of market are summarized as follows:

(1) Large number of buyers and sellers. The number of buyers and sellers is so large that no individual buyer or seller can influence the market price and output by his independent action.

(2) Homogeneous products. A firm produces a product which is accepted by customers as homogeneous or identical. There is no way in which a buyer can distinguish products sold by different sellers. The assumptions of large numbers of sellers and buyers and of product being homogeneous indicate that a single firm is a price-taker.

(3) Free entry and exit of the firms. Every firm is free to join or leave the industry. If the industry is making profits new firms can enter the market to share these profits. Similarly, if the industry suffers losses the individual firms can quit the market.

(4) No government regulation. There is no government interference in the market in the form of taxes, subsidies, rationing of essential goods etc.

(5) Uniform price. At a particular time uniform price of a commodity prevails all over the market.

The above five conditions are related to pure competition. Perfect competition requires the following additional assumptions/conditions to be fulfilled.

(6) Perfect knowledge of market conditions. Buyers and sellers have full knowledge of the price at which transactions take place in the market.

(7) Perfect mobility of the factors. Factors of production can freely move from one firm to another in the industry. They can also move from one job to another and in this way there is a scope for learning newer skills.

(8) Absence of selling and transportation costs. Selling and other promotional costs are not present in perfect market.

PERFECT COMPETITION

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

• Equilibrium price under perfect competition is determined not by the seller/firm but by the industry (all firms together).

• The price determined by the industry is accepted by all firms. Thus, individual seller/firm is a price taker under perfect market.

• This is explained with the help of diagrams below:

• In the diagram (Industry), DD and SS are the demand and supply curve respectively.

• The equality point of SS and DD is E, which is the equilibrium point. At this point, price OP is determined.

• OP price will be accepted by all firms in the perfect market and sell any amount of good at this price. Hence, average revenue curve faced by an individual firm is horizontal straight line parallel to the x-axis or perfectly elastic.

• Now, the firm’s task is to determine equilibrium output.

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

MONOPOLY

• The word ‘Monopoly’ has been derived from the two Greek words, ‘Monos’ which means single, and ‘polus’ which means a seller.

• Monopoly is a market situation where there is single seller of a product and he has full control over the supply of that commodity.

• He produces such a product which has no close substitutes. Thus monopoly market has the following features: 1. There is a single seller of the product. 2. There are no close substitutes of the commodity produced by monopoly seller. 3. There is restriction on entry or exit of other firms. 4. There is no distinction between a firm and an industry under monopoly. 5. Seller is a price maker. 6. A monopoly firm earns abnormal profits both in short and long run. 7. Selling costs are negligible. 8. A monopolist is capable of following price discrimination, which means it can charge different prices for its products from different buyers.

• Let us now see what the causes of monopoly are: 1. Monopoly can be the result of exclusive ownership of important raw materials or knowledge of production techniques; 2. Patent rights acquired by a firm for its product; 3. Foreign trade barriers imposed by the government, which prevents any foreign company to enter the industry. 4. A price policy adopted by the existing firms which prevents new firms to enter. The circumstances in which monopoly can exist • There are few firms that meet this requirement, if it is taken literally. • Is Microsoft a monopolist in the market of operating system? No, it has

a large market share, but Linux and Mac users would deny a lack of substitutes.

• Does MTN have a monopoly in telecommunication market? No, although it has a large market share.

• Does our local electric company have monopoly? Probably yes, if you mean delivery of electric power by wire, but there are existence of solar and other power generation by systems as substitute.

MONOPOLY

Varieties of Monopoly

• Closed monopoly: A monopoly that is protected by legal restrictions on competition.

• Natural monopoly: An industry in which long-run average cost is minimised when only one firm serves the market. Examples of natural monopolies are public utilities (gas, electricity etc)

• Open monopoly: A monopoly in which one firm is, at least for a time, the sole supplier of a product but has no special protection from competition. The first firm to venture into the market for a new product often finds itself in such a position, although other competitors may enter later.

MONOPOLY

How the profit-maximizing price and output for a monopoly are determined?

Quantity of

Output Price (₦)

Total Revenue

(₦)

Marginal

Revenue (₦)

Marginal

Cost (₦) Total Cost (₦)

Total Profit

(₦)

0 10.00 0.00 25.00 -25.00

1 9.75 9.75 9.75 4.60 29.60 -19.85

2 9.50 19.00 9.25 4.20 33.80 -14.80

3 9.25 27.75 8.75 3.85 37.65 -9.90

4 9.00 36.00 8.25 3.55 41.20 -5.20

5 8.75 43.75 7.75 3.30 44.50 -0.75

6 8.50 51.00 7.25 3.10 47.60 3.40

7 8.25 57.75 6.75 2.95 50.55 7.20

8 8.00 64.00 6.25 2.85 53.40 10.60

9 7.75 69.75 5.75 2.80 56.20 13.55

10 7.50 75.00 5.25 2.80 59.00 16.00

11 7.25 79.75 4.75 2.85 61.85 17.90

12 7.00 84.00 4.25 2.95 64.80 19.20

13 6.75 87.75 3.75 3.10 67.90 19.85

14 6.50 91.00 3.25 3.30 71.20 19.80

15 6.25 93.75 2.75 3.55 74.75 19.00

16 6.00 96.00 2.25 3.85 78.60 17.40

17 5.75 97.75 1.75 4.20 82.80 14.95

Explanations from the table and graph • A monopolist maximizes profits by producing

the quantity of output for which marginal cost equals marginal revenue.

• The price it charges for the product is determined by the height of the demand curve (rather than the height of the marginal revenue cost curve) at the profit-maximizing output.

• Beyond 13 units of output (the profit-maximizing level in this case), total revenue continues to rise for a while, but profit falls because total cost rises even more rapidly.

Profit Maximization or Loss Minimization • If the market conditions are unfavourable, a monopolist, like a

perfectly competitive firm, may be unable to earn a profit in the short run.

• In such case, it will aim to minimize losses. Whether a profit is possible depends on the position of the demand curve relative to the firm’s average total cost curve. The possibility of a loss is shown in Figure below.

• Sometimes, costs may be too high in relation to demand to allow a monopolist to earn a profit.

• In this graph, for example, the demand curve lies below the average total cost curve at all points. The best the monopolist can do in the short run is cut losses by producing at the point at which marginal cost equals marginal revenue.

• If the demand curve were to shift downward even further, preventing the firm from obtaining a price that would cover average variable cost, the short-run loss-minimizing strategy would be to shut down.

A monopolist suffering a short-run loss

• We see, then, that being a monopolist does not guarantee that a firm will be able to earn profit.

• It can do so only if cost and demand conditions allow the product to be sold at a price that exceeds the cost of producing it

How long-run equilibrium is achieved under monopoly

Situations of consideration under monopoly conditions in the long run are:

a. Long-run Equilibrium without Treat of Entry

• The simplest situation is that of a monopolist that faces no threat of entry into its market by competitors. For such a firm, a graph such as Figure 1 can represent long-run as well as short-run profit maximization, only the interpretation of the curves changes. The curve that is labelled average total cost curve in Figure 1 would now be interpreted as firm’s long-run average cost curve, allowing for free adjustment of fixed inputs as in the long-run competitive case. The marginal cost curve would be the corresponding long-run marginal cost curve, and the demand curve would be the long-run demand curve. The long-run equilibrium would occur at the output where long-run marginal cost equals long-run marginal revenue, and the long-run equilibrium price would be given by the height of the long-run demand curve at that point.

b. Open Monopoly, Entrepreneurship, and Limit Pricing

• Consider long-run equilibrium for an open monopolist. Such a firm is currently the sole supplier of its product but is not protected by the decisive cost advantages of a natural monopoly or the legal barriers to entry of a closed monopoly. With little or no built-in protection from would-be rivals, what options does it have?

• One option is to push the price all the way up to the short-run profit-maximizing level, enjoy pure economic profits while they last, and accept that sooner or later other firms will enter the market and take away part or all of those profits. Example is the consumer electronics industry.

• An alternative strategy is to set a somewhat lower price, one that gives it a moderate profit but at the same time makes the market a less attractive target for would-be competitors. Such strategy is called limit pricing because it limits short-run profits in the hope of limiting entry.

c. Closed Monopoly and Rent Seeking

What kinds of pricing strategies are used by monopolies and other price-searching firms

1. Price Discrimination • The first pricing strategy is that of charging different prices to different buyers for the

same product. When the prices charged to different buyers do not simply reflect differences in the costs of serving them, the firm is said to practice price discrimination. For example, a theatre that charges adults ₦10 for a seat and children ₦8 is practising price discrimination; the cost of providing a seat to a child and to adult is the same.

2. Conditions for Price Discrimination • It must be impossible or at least inconvenient for buyers to transfer or resell the

product. • The seller must be able to classify buyers into groups on the basis of the elasticity of

their demand for the good. Those with highly inelastic demand can then be charged high prices and those with more elastic demand can be charged lower prices.

3. Two-Part Pricing • Under two-part pricing, customers first pay for the right to become a buyer, and only

then have the right to buy as much as they want at a fixed per-unit price. To give them general names, the amount paid to become a buyer can be called the access fee and the price per unit, once the access fee has been paid, can be called the user charge.

• Examples of two-part pricing are: Utilities like electricity and telecommunication charges in purchasing SIM cards and meter. Two-part pricing is especially popular in markets where fixed costs are high and marginal costs are comparatively low.

MARKET PERFORMANCE UNDER MONOPOLY

A. What to produce: Consumer and Producer Surplus

• The concepts of consumer and producer surplus provide a useful tool for analysing market performance with regard to the quantity of each good that is produced.

• Figures below make the comparison between perfect competition and monopoly.

• Under perfect competition, shown in part (a), production is carried out to the point at which the price consumers are willing to pay for the last unit produced just equals the opportunity cost of producing it.

• All possible gains from trade are realised in the form of producer and consumer surplus. Under monopoly, production stops short of that point.

• Consumer surplus is smaller and producer surplus larger than under competition, but the total of the two is smaller. Some potential gains from trade go unrealised.

• This deadweight loss is the reason monopoly is considered a form of market failure.

• Dead weight loss is a loss of consumer or producer surplus that is not balanced by a gain to someone else or any benefit that is lost by one party but not gained by another.

MARKET PERFORMANCE UNDER MONOPOLY

B. How to Produce: Average Total Cost in Monopoly Equilibrium

• The equilibrium output for a monopoly can occur at any point along its long-run average cost curve. Thus, monopoly cannot lay claim to minimization of average total cost and in this respect can be said to be less efficient than perfect competition.

• How serious the efficiency is in practice depends on circumstances. Three cases need to be considered.

• In the case of natural monopoly, equilibrium will usually occur at an output at which the firm is still experiencing economies of scale. Dividing the industry’s total output between two or more firms would mean that each of them would have to operate at an even lower, and hence less efficient, level of output. Thus, although the natural monopoly produces an inefficiently low level of output, it produces that output at the lowest possible cost given the demand and cost curves for the product.

• Empirical cost studies indicate that many firms experience approximately constant returns to scale after a minimum efficient scale has been reached. If demand for the product is sufficient so that the profit-maximizing equilibrium output for such a firm is greater than that minimum efficient scale, that output will be produced at the minimum possible cost.

• The equilibrium output may lie on the rising portion of the monopolist’s average cost curve, where it encounters decreasing returns to scale. In this case the monopolist not only produces an output that is too small to realize all potential consumer and producer surplus, but also produces that output at an inefficiently high cost.

MARKET PERFORMANCE UNDER MONOPOLY

How monopoly affects market performance

• Monopoly can be a source of market failure in that the amount of output it produces is less than the amount that would make marginal cost equal to the price charged.

• As a result, some consumers who would be willing to pay a price that is higher than marginal cost are unable to buy from a monopolist.

• Because, some gains from trade (consumer and producer surplus) are not realised under a simple monopoly, there is dead-weight loss to the economy.

• However, strategies like limit pricing, two-part pricing, and price discrimination may reduce the deadweight loss.

• Finally, under long-run equilibrium conditions a monopoly does not necessarily produce at the point of minimum long-run average cost.