Explain why the level of profits differs between market structures

Explain why the level of profits differs between market structures

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Introduction

In the present business world, the assumption is that firms would like to maximize profits, but in the real life maximizing profit has a great impact on the society and the economy (Wigley 1996). Industries fall under different market structures. There are four types of market structure; perfect competition, monopoly, monopolistic, and oligopoly. The main factors that influence a market structure are; the number of buyers and sellers, the degree of product differentiation, the knowledge of buyers and sellers regarding a commodity and the strengths of barriers to entry and exit. Different industries have different market structures leading to a different in the level of profits (Anderton 2008). A firm can realize normal or abnormal profits depending on its type of marketing structure.

Definition of terms

Level of profit-A representation of the amount of cash acquired by a certain industry above the cost of production

Market structure-A description of the key factors determining the degree of competition in a market

Normal profit-The minimum level of profit that a firm requires to achieve in order to keep factors of production in their present use in the long run

Abnormal profit-Any profit, a firm, achieves in excess of the normal profit.

Discussion

Market structures

Perfect competition

A perfect competition marketing structure is made up of several firms producing similar products and sold at the same market price. Perfect market structure is rarely found. Industries under the perfect competition market include the stock market (Begg 2009). For example in United Kingdom 2011, the Competition Commission made the Payment Protection Insurance a monopoly firm.

Profit maximization in a perfect competition market structure

Firms in this industry must assume profit maximization, and any profit made by a firm belongs to the owner. In the short run, a firm under the perfect competition structure has fixed resources and only maximizes profits by adjusting its outputs. Firms only produce when the difference between total revenue and total cost is greater than zero. On the other hand, the fixed cost must be less than the loss. If the firm’s loss exceeds its fixed cost, it is banned from producing and must shutdown in the short run. When a firm shuts down, its losses equal its fixed costs (Begg 2009).

Monopoly market structure

On this market structure, a single firm is the only producer of a product or services and there exist no close substitutes. Examples of monopoly market structures are the professional sports leagues and public utilities.

Profit maximization in monopoly market structure

The Marginal Revenue (MR) = Marginal Cost (MC) (MR=MC) rule gives the profit maximization output of a monopoly firm. Monopolists do not change the highest price possible, but maximizes profit where Total Revenue (TC) minus Total Cost (TC) is the greatest. The profit level depends on the amount sold and also the price. Monopolist can change the price of a commodity in order to increase the profit output level (Wigley 1996).

Comparing and analyzing the characteristics of Monopoly and Perfect Competition

Homogenous product versus unique product

Firms under the perfect competition market structure sells homogeneous products. The market structure composes of a large number of small firms selling identical products. A monopoly market structure offers unique products, and there are very few substitutes. As a result of offering a unique product, the monopoly market structure charges higher prices while producing less while the perfect competition offers low prices and high production output. Figure 1 shows demand curve for a firm under the perfect competition in the short-run. The increase in price of products in perfectly competing firm leads to decreased demand. The blue flat line shows that D=AR=MR, meaning demand (D) equals average revenue (AR) that equals marginal revenue (MR). In the short run, profits are greater than zero in a perfect competition (Wigley 1996).

Figure 2 shows the demand curve for a firm in monopoly market structure in short-run. From the graph, an increase in demand has no effect on the quantity demanded. Since the firm sells unique products, customers will always demand the product irrespective of the quantity and price. As shown on the graph, profits equal zero (profits=0). The green section shows profit while the pink section indicates the dead weight loss (DWL).

Figure 1: demand curve for a perfect competition

Figure 2: Demand curve for a monopoly market structure

Many firm sellers versus only one firm seller 

A perfect competition market structure composes of many firms with many sellers while a monopoly market structure is composed on one firm/ one seller. Sellers in a perfect competition are many that one seller’s decision has no impact on the market price. In the monopoly market, the price is higher than the marginal cost of production giving suppliers freedom to influence the price (Gillespie 2007). This can be shown in the curve labeled MC on figure 2.

Free entry & exit and barrier entry

Firms in a perfectly competitive market have no barriers to entry or exit, a firm can freely enter or exit an industry based on its market perceptions and level of profit. As seen in figure 3, at the long-run, free entry of firms to the industry affects the profits of only one particular company. At this level, price, marginal revenue, and average revenue are equal (P=MR=AR). On the other hand, a monopoly market structure has barriers to entry and exit. Firms under this industry have limited movements in and out of the industry (Gillespie 2007).

Figure 3: demand curve for a perfectly competitive market in long-run (barriers to entry)

Price taker and choosing own price

Firms in a perfect completion market structure pick prices decided by various firms while monopoly firms chose their own prices. In a perfectly competitive market structure, the price is optimal meaning a shift in the price has a significant benefit on one firm. The price of the product of service in a perfectly competitive market equals the marginal cost of manufacturing the particular good or service. A single seller in a monopoly structure makes decision regarding the price and the amount to produce because there are no substitutes.

The difference between normal and abnormal profits in perfect competition and monopoly

Perfect competition market structure

In case the four characteristics of a perfect competition market are met, the firm is referred to as being in a perfect competition. A firm in this market structure might find it possible to make abnormal profits in the short-run. As shown in figure 5 below, the point where the firm’s price (Average Revenue) goes beyond its Average Cost forms a situation where it can make abnormal profits. The MC cuts the AC in the lowest point where MC=MR. A firm experiences profit maximization at any point above that.

Figure 4: abnormal profit for a perfect competitive firm

On the other hand, the period of making abnormal profits for a firm in the perfect competitive market is limited to free knowledge of information, factors of production and lack of barriers to entry that can attract new industries to the market. Entry of new firms pushes the supply curve to the right (Sloman 2006). Figure 4 shows that a shift of supply curve to the right pushes prices down leading to low revenue. A change in output of an individual firm has no effect on the market price. The firm then makes normal profits in the long-run when more than one firm leaves or enters the competition.

Figure 5: Changes in supply curve due to entry of a firm in a competitive market

Monopoly response to abnormal profits

As similar to a perfect competitive market, the monopoly also maximizes profits in the short run. Since a monopoly is the sole supplier to the market, its demand curve is similar to that of the market. Abnormal profits occur where MC=MR as shown in figure 6.

Figure 6: response to abnormal profit in a monopolist

On the other hand, monopoly firms experience loss at the long run, but continue operating because they always make normal profits as opposed to perfect competitive firms who cannot run at a loss in the long run. Most monopoly firms experience a break-even in the long run. The price goes beyond marginal cost during the long run, a clear indication that consumer’s value additional units. Average costs in a monopoly might be higher than in a perfect competition because a firm in perfect competition incurs advertising costs in order to attract more customers than competitors. In addition, consumers have choices from many categories, types, brands, and different quality products (Sloman 2006).

Analysis of price discrimination to increase abnormal profits under monopoly conditions

Technology in the form of the internet has given firms the capability to gather and store information on the past market behavior of consumers and make use of this information to set different prices. Technology enables monopolists gather more information on prevailing market prices for products in different countries and decide their prices appropriately. Price discrimination refers to selling of goods or services at many different prices independent of the cost differences (Gillespie 2007). The following conditions must be fulfilled for price discrimination to occur:

A firm must identify different market segments (example, domestic users and industrial users)

Different segments should have varying price elastic demands (PEDs)

Every market should be separated from another by time, location or nature

Firms must be monopoly

Figure 7 shows curves for price discrimination using elastic and inelastic curves. Assuming the marginal cost (MC) to be constant in all markets, it then will be equal average total cost (ATC). Under this condition, profit maximization occurs where MC = MR. When markets are separated, the price and output is represented by P and Q in the inelastic curve and P1 and P2 in the elastic curve. In separate markets, profits are only realized in shaded areas on both curves. A monopolist achieves price discrimination when the profit realized from separating a sub-market exceeds the profit for combining them. Firms benefit from price discrimination if the profit achieved from separating the markets is greater than from that achieved from combining the markets. In the inelastic market, consumers pay high prices for products while those in the elastic market pay lower prices (Economics Online 2013).

Figure 7: Price discrimination using elastic and inelastic curve

Natural monopoly and government monopoly

A natural monopoly is a monopoly market structure in the industry involving the least long-run average cost of production while concentrating in a single firm. Natural monopoly market situation provides the largest supplier in the market and enjoys high cost advantages. On the other hand, a government monopoly (public monopoly) involves government agencies and corporations as the sole provider of specific products or services and there is no competition. This monopoly is created by the government where a private individual or company gets tender from the government (Agarwala 2009, p. 148).

How government policies could be used to change monopoly into perfect competition

The government should introduce policies that ensure the monopoly structure change into the perfect competition. The government should create no barriers to entry or exit in the monopoly structure so that any potential firm has the freedom to enter the market. Additionally, the government should be the only body setting prices all firms in a monopoly market structure in order to ensure every firm markets its products and create a competition.

Some monopolistic firms can be inefficient if converted to perfect competition. For example, the U.S. Postal Services cannot perform in the perfect competition industry. Introduction of close substitutes in this industry would lead to many competitors who have quality marketing skills. Good examples of losses that this firm can make include losing its revenues in intensive advertisements and promotions.

Conclusion

The above discussion clearly shows why the level of profits differs between market structures. Two types of market structures have been discussed and their characteristics analyzed. From the analysis, there is open evidence that monopoly firms will continue experiencing high profit levels compared to firms in the perfect competition. A monopolist can change the price of a commodity in order to increase the profit output level while a perfect competitor must sell products at the determined price. On the other hand, even though monopoly market structure can offer advantages to customers, such as like lower prices, because of the economies of scale this type of market structure is not recommended. Firms under the monopoly structure sell their products at higher prices but produce low efficient products due to lack of competition (Doyle, Peter and Stern 2006).

List of references

AGARWALA, S. K. (2009). Principles of economics. New Delhi, Excel Books.

 ANDERTON, A. G. (2008). A level economics for AQA (4th Edition). Harlow, Longman.

BEGG, D. (2009). Foundations of economics. London, McGraw-Hill Education.

DOYLE, PETER AND STERN, PHILLIP. (2006). Marketing management and strategy

(4th Ed). Prentice Hall, Pearson Education Ltd

ECONOMICS ONLINE. (12 May 2013). Price Discrimination. Economics Online. Retrieved 01

Mar. 2014 from:

http://www.economicsonline.co.uk/Business_economics/Price_discrimination.html

GILLESPIE, A. (2007). Foundations of economics. Oxford, Oxford University Press.

SLOMAN, J. (2006). Economics. (6th Edition). New York, NY

WIGLEY, J. (1996). Introductory Economics (6th Edition), G. F. Stanlake and S. G.

Grant. Economics and Business Education : the Quarterly Journal of the Economics Association. 4, 40.