Are you an investor or do you aspire to be one?
Then you should probably know the importance of studying the markets.
A major chunk of an investor's time goes into religiously following the market, as a slight change of momentum might bring a tumult in their life. Even for a normal guy, it becomes crucial to oversee the markets to manage the expense and stay ahead of the curve.
But to read the market, you also need to understand the basic parts of it, right?
So today, we will get an overview of the different types of market structures, and how it's affected by the outer forces.
How do you define a market?
A market is a group of buyers and sellers that are aware of each other and are able to agree on a price for the exchange of goods and services.
Factors determining the market structure
Number and relative size of firms supplying the product
The degree of product differentiation
Power of seller overpricing decisions
Relative strengths of the barrier for market entry and exit
Degree of non-price competitions
Types of market structures
We will now start with understanding each market structure and will go a bit deep into it.
Perfect competition
The characteristics that define a perfectly competitive market are :
There are a large number of potential buyers and sellers.
The products offered by the sellers are virtually identical (products are similar)
There are few or easily surmountable barriers to entry and exit
Sellers have no market pricing power
Nonprice competition is absent
An example could be a market for oranges or apples
Demand analysis
One key point here is the market demand curve is downward sloping. If we take the example of the orange market. It must be fairly understandable that if the price of oranges increases, the buyer will reduce buying it.
Let us understand its demand curve a bit. Say our demand curve equation is:
Quantity = 50 – 2*Price or in other words, P = 25 – 0.5Q
Total revenue (TR) would be = Price * Quantity = 25Q – 0.5Q^2
Marginal revenue (the revenue that results from the sale of one additional unit of output) = change in Total revenue/change in quantity.
After differentiating the above equation wrt Q, we get, MR = 25-Q
Its graph would look something like this
Elasticity of demand
The elasticity of demand can be thought of as the sensitivity of quantity demanded to the price of an item. In other words, what would happen to the quantity demanded of an item if its price changes.
Let us see what are the factors that change the price elasticity of demand.
The number of substitutes for the products available in the market. If the number of substitutes increases, the elasticity also increases. This could be understood by taking an example. Say product A has a lot of substitutes, whereas product B has only a few. Now if both Product A and B increase their prices, consumers of product A can shift to some other company reducing its quantity demanded to a large level. On the other hand, as there are not many substitutes of product B, the quantity demanded will also reduce but to a small extent.
Share of consumer’s budget spent on the item. Say an item has a significant price and depicts a larger portion of the consumer’s budget. If the price increases, its demand will also be affected drastically, making the elasticity high. For example, on one hand, you have an automobile company and on another, you have a coffee company. As a car would take a large portion of your budget, if the company chooses to increase its price, you would think twice or might delay your buy, making its quantity demanded low. However, a change in coffee price won’t bother you much as its original price wasn’t too high n the first place.
Length of time within which demand schedule is being considered. If the time frame under which we are calculating the elasticity increases, the elasticity also increases simultaneously. Say the prices of petrol increases by a lot. In a small timeframe, this won’t affect the demand for petrol as the consumer has no choice. However, in the long run, the consumers might install CNG tanks and shift to a CNG fuel system. The quantity demanded of petrol will then change drastically, making the elasticity very high.
Some other factors affecting the demand could be –
The change in public income. This can be calculated using the income elasticity of demand.
Elasticity = % change in quantity / % change in Income
Change in price of the substitute or complement. This can also be calculated using the cross-price elasticity of demand.
Elasticity = % change in quantity / % change in the price of substitute or complement
Complement can be thought of like an eraser to a pencil. If the price of pencils increases by a lot, the demand for erasers would also reduce.
Supply analysis
When market prices increase, firms supply greater quantities, which should be quite obvious. The market supply curve then becomes the sum of the curves of individual firms.
Optimal price and Output
Optimal price or the equilibrium price can be calculated by combining the market supply and demand functions. Individual firms have to then sell at the equilibrium price obtained.
The output could be understood by looking at the graph here.
The price and the quantity they should sell at to get the maximum profit can be found at the position where the Marginal Revenue = Marginal Cost, which is 5.71
The Quantity hence would be Qmax. The price equivalent of the lowest point of the average total cost (5.00) depicts the minimum price the company should charge for an item to not have a loss.
So, the economic profit the firms can expect is the rectangular region (highlighted) between 5.71 and 5.00.
If for some reason, the optimal price increases, the supply will also increase and the Price and quantity equivalents will be along the MC curve (along the arrow)
Factors affecting the long-run equilibrium in perfectly competitive markets
Here, as we have seen that the firms are expecting an Economic profit > 0.
This will attract more such firms making the overall supply curve shift to the right.
This shift will result in the dropping of prices, and as the price drops, the economic profit will come down to 0. No additional firms will then enter the market.
So in perfectly, competitive markets, firms will come and go making the overall economic profit 0
Monopolistic competition
Characteristics that define monopolistic competitive markets are –
There are a large number of potential buyers and sellers
The products offered by each seller are close substitutes for the products offered by other firms, and each firm tries to make its product look different
Entry into and exit from the market are possible and fairly low costs
Firms have some pricing power
Suppliers differentiate their products through advertising and other non-price strategies
One example that can be thought of is the market of toothpaste
Demand analysis
The demand curve here again is downward sloping for each firm. Profit maximizing quantity is where MR = MC (Shown in the graph below). The price will be set equivalent to the demand curve.
Again, the economic price would be the same.
Supply analysis, optimal price, and output
Output is based on where we have the most profit (MR = MC)
Price is based on the demand curve, shown above
The supply function is not well defined. Contrary to the perfect competition, the demand curve is downward sloping.
Prices are higher and the quantity demanded is lower compared to perfectly competitive markets. This point would be clear in the next section.
Factors affecting long-run equilibrium in monopolistically competitive markets
In the long run, the economic profit is again 0. See the graph below,
If the firms are earning EP>0, other firms will enter the market. hence the demand curve will shift from D1 to D2
As for maximum profit, MR = MC, the quantity of equilibrium will be Q2, and the corresponding price will be P2.
Now, as we already know at the bottom of ATC, EP = 0. In a perfect competition where Economic profit = 0, the price (P1) should be at the bottom of ATC and the corresponding demand should be Q1.
So the point being made in the previous section that why prices are higher and the quantity demanded is lower compared to perfectly competitive markets should be clear to you now
Now, you might think why do we pay high here than in the perfectly competitive markets. There are no absolute answers to this. You might think of it as this way. We pay more here because we get more options here.
Oligopoly
Characteristics that define oligopoly markets are:
There are a small number of potential sellers
The products offered by each seller are close substitutes for the products offered by the other firms and may be differentiated by brand or homogeneous and unbranded
Entry into the market is difficult, with fairly high costs and significant barriers to competition.
Firms typically have substantial pricing power
Products are often highly differentiated through marketing, features, and other non-price strategies.
There is a temptation to collude, meaning the few firms might join to firm a cartel and set a high price.
Examples can be Coke and Pepsi
Demand analysis and pricing strategies
If the firms collude, market demand is divided and the companies set the price according to them
If the firms do not collude, each firm faces an individual demand curve, and market curves will demand on pricing strategies. A short introduction is given on each strategy below:
Pricing interdependence – Pricing of players is independent. Competitors will not follow a price increase but will cut prices in response to a price decrease.
Cournot Assumption - Each firm determines profit-maximizing quantity assuming the other firms’ output will not change. In other words, we do not consider the actions of other firms
Nash Equilibrium – here, firms arrive at an equilibrium strategy after considering the actions of other firms. No incentives for any firm to deviate from the Nash equilibrium.
Supply analysis
There is no well-defined supply function. However, we can understand the quantity demanded and the profit-maximizing price by taking an example of a dominant firm oligopoly (One leader firm in the whole market)
Say, we have an oligopoly market where one firm has a significantly lower cost of production than its competitors and has a 45% market share, and there are 4 other firms.
The demand curves can be shown as –
Again, the profit-maximizing price will be at where MR = MC
Here, Qleader will be the quantity supplied by the leader at Price PL. Other firms will most probably charge the same amount as their cost of production is already high relative to the leader. Overall Quantity is shown at Qoverall.
0->A = quantity supplied by the leader
A->B = quantity supplied by other firms
Also, the demand function of the market and leader seems to collide as the price reduces. That’s because at such low prices, other firms might not be able to sustain, making overall quantity supplied equal to the quantity supplied by the dominant firm.
Few other key points to note about oligopoly markets:
No single optimum price and output model works for all oligopoly market situations.
In long run, economic profits are possible. Evidence suggests that over time, the market share of the dominant firm declines
Monopoly
Characteristics that define monopoly markets are:
A single dominant firm is present
Barriers to entry are very high
The product offered is unique
Firms set the price according to them. In other words, Pricing power is very high
One example could be the government or the supplier of electricity.
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