market structures in detail and analyses the pricing strategies that the firms have to undertake when they operate in different regimes. The case study on Toyota is considered next, which indicates that firms competing in various structures does not only have to focus on price and quantity ceteris paribus, they also have to consider external and internal variables that have a bearing on these decisions.
Introduction to Market Structures
Market structures are important parts of economic theory as they model market behavior that can help economists explain activities in industry with ease. Market structures, hence are basically models that define market behavior with respect to certain criteria so that it becomes simpler to compare events in real life to the postulated scenario as described in theory in order to be able to determine casualties and to define optimal strategies that firms operating in different market structures can use.
There are four main different kinds of market structures defined by the number of buyers and sellers in the market, as well as by various other criteria, such as the availability of information and the level of product differentiation.
Perfectly competitive markets are structures with many sellers and a homogenous product that makes for numerous firms selling the same product without any differentiation. This market is characterized also by free information that is available to all players.
Perfectly competitive market structures have numerous players selling the same product to buyers who are fully informed, so that firms have to set competitive prices in order to be able to sell their products to buyers. This means that if a firm sets its price below a level that other sellers are asking for, the firm will forgo profit that it could otherwise make and will therefore tend not to make such a decision.
On the other hand, if the firm were to set its price above the market level, it won't have any buyers, as all of them would have the information regarding other sellers, asking for lower prices, and would tend to restrict their transactions to those having a lower price.
The price and quantity that each firm sells is determined by the rules of demand and supply.
The point where demand meets the supply of the product is what sets the equilibrium determining quantity demanded and the price at which it is supplied. Looking at each individual firm's price setting structures, the determinant of quantity is the cost it incurs in manufacturing the product.
This can be defined by the cost curves and graphs below:
AR =MR= P
The graph above has price set at the market level which is its average revenue and its marginal revenue as well, as each additional unit of the product yields the same amount of increasing revenue. Moreover, where the average cost curve and the marginal cost curve intersect is the point at which the average cost is at the lowest.
Therefore the point at which the firm will be able to earn the highest level of profits is where AR and AC intersect.
The company that operates under this pricing regime are farmer selling potatoes in California. There are numerous sellers of potatoes who sell the same product which is not differentiated. Therefore the farmers have to adopt the rationale that is relevant to the pricing regime as explained above.
A monopolistic structure is where there is only one seller of the product and there are many buyers. Such a market structure happens generally in the case of a utility or a product or service where the state restricts the number of suppliers in order to make the industry efficient. Moreover, the product or service might require heavy investment which many private companies might not be able to make, leaving the state to invest in that industry, and the state creating a monopoly in order to keep costs low.
The graphical representation of this structure is as follows:
A firm in the monopolistic structure decides the quantity at which to produce, and this decision is based on where the marginal revenue curve meets the marginal cost curve. This is the point where the profits are going to be the highest. The quantity produced, therefore is at point Q. whereas the price is decided by the average revenue curve, which is the demand curve for this product. The costs for this level of output are determined by looking at the average costs at this level of output Q. The rectangle formed by P. And C. depicts the profits made by a monopolistic firm. If the firm wants to increase its profits, it will be able to do so by bringing its costs down.
Monopolies in some cases, especially if they are regulated by the government may be made to restrict the quota of their supplies or might be asked to produce what is more than their optimal quota. In such a case inefficiencies exist as the firm is restricted by law to not to be able to produce as much as is most profitable for it.
A real life example of this company is AT&T which was initially operated in the U.S. As a monopoly, where the government wanted to create efficiency in the market by offering the services by only one firm, which would reduce repetition of the service and allocate resources so that none were repeated in competition.
This is the case of firms operating in a competitive market but are selling differentiated goods that are different based on the variety of features that they offer to their customers. Firms in monopolistic competition have lower profits than those available to monopolies due to the availability of substitutes. The graphical representation of the market is as follows:
Profits in the case of firms operating under monopolistic competition are lower due to the higher number of firms operating in the market. Although the products on offer under this regime are differentiated based on quality, ingredients or service levels, the fact that they can be replaced by similar products with a few different features makes the case for profits being lower.
As in the case of monopolies here too, the demand curve of the industry is the AR curve, which is downward sloping as there are many other firms competing in the market as well.
This market is also characterized by decision making that decides on the level of production based on t he intersection of marginal revenue and marginal cost curves as after this point, the marginal costs start increasing, diminishing returns to scale set it, and the firm becomes less profitable if it produces at any level beyond this point. Firms also do not produce at points to the left of this intersection as the profit level at these points is lower.
An example of a firm competing in such a market is Procter and Gamble selling its Head and Shoulders brand of shampoo with anti-dandruff features. The shampoo has to be prices similar to other brands of shampoo such as Clear by Unilever, as both the products are differentiated and yet offer the same benefits.
An oligopolistic market structure is where there are a few large firms competing in the market.
According to Samuleson:
"Oligopoly represents an intermediate case: The industry is dominated by a small number of firms and is marked by significant, but not prohibitive, entry barriers."
This market structure is different from others in the sense that here, competitors strategy are a very important consideration. The game theory has been applied in many cases to oligopolistic firms which are selling similar products, but because they are very few in numbers each competitor's action has a bearing on the other's strategy.
The demand curve for oligopolies is unique as it is kinked. The graphical representation is as follows:
The reason for the kinked demand curve is simple. The few firms that exist in the market have a tendency to attract customers based on price wars. But the effectiveness of price wars lies in how elastic the demand for the firm's products is. The tip of the MR and AR curve the demand is elastic so a minor change in price will lead to the demand falling by a greater quantity. Moreover, the profit margins are lower when demand is elastic indicating that the firm's products are easily substitutable.
As far as the lower portion of the graph is concerned, the graph indicates relative inelasticity, (Moffatt, n.d, para 6) so that changes in price don't change quantity by a greater amount. The kink in the curve therefore is the limit to which producers can take the price level, beyond this price, customers start substituting the product. Therefore the biggest challenge of management in oligopolies is determining where the kink lies.