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--THINK AHEAD--
"You operate in a market of hundreds of small firms that produce exactly the same product that consumers all know is identical in quality to every other firm's. You can't get any competitive advantages; you produce exactly the amount of units that maximise your profits (When the price they receive matches the cost of the last unit 'the marginal cost'), which is just enough to stop you from leaving and doing your 2nd highest-paying job, and you can sell out at the market price every day. Do you a) 'raise your price,' or b) 'lower your price,' or c) "Do nothing?"
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"Well, firstly, you can't 'raise your price' as all consumers know there is a cheaper, exact substitute; secondly, you won't 'lower your price' as you are already selling out at your profit-maximizing level at the market price. So, you are happy to 'do nothing' and be a 'price taker,' rather than a 'price maker. In other words, you have a perfectly elastic demand curve at that single price with no 'price-setting ability' due to 'perfect competition'."
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"Is this scenario realistic?" "Surely no goods are 100% identical." "Do consumers really have perfect knowledge?" "Surely you have some ability to raise prices without losing all your customers?", "Can't you use persuasive advertising or enforce patents and copyright?" "Surely you can become more productive and lower your prices to beat your rivals and start a price war, right?"
--MARKET POWER & COMPETITION--
--MARKET POWER & COMPETITION--
Market power refers to THE DEGREE TO WHICH A FIRM IS ABLE TO RAISE ITS PRICE WITHOUT LOSING A SIGNIFICANT NUMBER OF ITS CUSTOMERS ('PRICE-SETTING ABILITY')
The extent to which this is possible DEPENDS PRIMARILY ON THE NUMBER AND CLOSENESS OF SUBSTITUTES AVAILABLE (LEVEL OF COMPETITION), which in turn is determined by how well it can DIFFERENTIATE ITSELF from its rivals. In summary...
HIGH <--LACK OF COMPETITION--> LOW
HIGH <--PRICE SETTING ABILITY--> LOW
HIGH <--DIFFERENTIATION--> LOW
--THINK AHEAD--
"If you can sell all your output at the same price, is your average revenue, marginal revenue, and price the same?" "If you need to lower your price to sell more, is this also the case?"
--"WHY IS IT A MARKET FAILURE?"--
--"WHY IS IT A MARKET FAILURE?"--
"To understand why we need to revisit the assumption that all rational firms will 'seek to maximise profits,' and thus produce up to the level of output where the cost of producing the final unit ('the marginal cost') is just slightly below (so slight we can just say 'equal to') the price they receive on that final unit ('the marginal revenue'), in other words, where 'MC = MR'
"In the above-mentioned 'unrealistic' scenario, all firms still produce at this level; however, without market power, they simply sell out at the one price, so the marginal revenue is the same for each unit sold (P=MR). However, with market power they have a downward-sloping demand curve due to differentiation from their rivals; hence, when they sell more and lower the price, the MR is actually less than the price.
ve of every unit is the marginal cost socially optimal level, and hence there is no market failure, as the price they receive is equal to the marginal revenue they receive (horizontal demand curve); however, when a firm has market power, it gives you price-setting ability, and a downward-sloping demand curve, right?" "Yes, but so what?"
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per unit
have downward-sloping demand curves, the price changes
market power, they restrict output to raise prices and maximize profit.
As a result, they produce less than the socially efficient level. This leads to underproduction and a loss of total welfare compared to perfect competition.”
The don't maximise profits at the
A competitive firm: “I can sell more without lowering price, so I produce until price equals cost.”
A firm with market power:
“To sell more, I must lower price, which reduces revenue. So I stop earlier.”
According to competitive market theory the equalibrium price is equal to margibal cost (P=MC), and implies ever producer is a 'price taker' and must accept this price as if they were to raise it then consumers would simply buy the identical substitite
The ability to set prices implies firms do not have to accept the free market competitive price (which rather unrealistically assumes 'PERFECT COMPETITION', which we will look at in more depth later) and this in turn implies they do not need to produce at their allocatively efficient levels, rather they will produce at a level that MAXIMISES PROFITS, which you will soon see means that they will ALWAYS PRODUCE at a level BELOW THEIR EFFICIENT LEVEL, and hence UNDERPRODUCE.
--SOURCES OF MARKET POWER--
--SOURCES OF MARKET POWER--
As mentioned above, the main determinant of MARKET POWER is the LEVEL OF COMPETITION, which is heavily influenced bxxxy the level of DIFFERENTIATION, for each type of firm below, decide whether they have a significant amount of MARKET POWER and explain your answer in terms of the LEVEL OF COMPETITION and DIFFERENTIATION they face.
For each of these firms consider the following questions:
"Is the same price charged by all firms in the industry?"
"Is it able to raise its price and still keep some of its customers?"
"Do they produce completely identical products?"
"Is it just one of thousands of small-scale firms?"
"If it left the market, would the market price rise?"
"If it's profitable, can new firms easily enter the industry to compete?"
"Do all consumers know about the existence of substitutes?"
--1) NOODLE STALL IN HAWKER'S MARKET--
-2) ORGANISATION of PETROLEUM EXPORTING COUNTRIES-
--3) FRUIT STALL IN A WET MARKET--
--4) SINGAPORE MTR--
--5) ADIDAS TRAINERS--
--6) OVERSEAS FAMILY SCHOOL--
--7) MONEY EXCHANGERS--
--INITIAL THOUGHTS--
--INITIAL THOUGHTS--
So far, all our models have depicted the 'market' for a particular product, which is assumed to be supplied by many producers, who enter/exit the market when the equilibrium price changes, however for this to occur we are making some very UNREALISTIC ASSUMPTIONS that rarely apply in the real world.
To illustrate these inaccurate assumptions imagine that we had a supply and demand diagram showing the market for IBDP schools in Singapore. For this to be an accuarte are assuming the following:-
There is a SINGLE PRICE CHARGED for all IBDP courses by all Singapore-based international schools. NOT TRUE!
If OFS was to RAISE ITS PRICE above this level, 100% of CUSTOMERS WOULD LEAVE to go to a rival school, that offers an PERFECT SUBSTITUTE. NOT TRUE!
OFS is UNABLE TO DISTINGUISH ITSELF in any way whatsoever from its rivals in the eyes of customers (e.g through location, design, facilities, marketing etc...) and thus they PRODUCE COMPLETELY IDENTICAL PRODUCTS. NOT TRUE!
OFS is just ONE OF THOUSANDS OF SMALL-SCALE SUPPLIERS of the IBDP in Singapore with no ability to grow in size and therefore HAS NO IMPACT ON THE OVERALL MARKET SUPPLY. NOT TRUE!
New schools freely ENTER the market whenever demand increases and EXIT the market when demand decreases. NOT TRUE!
--WHY IS IT A MARKET FAILURE?--
--WHY IS IT A MARKET FAILURE?--
The ability to set prices implies firms do not have to accept the free market competitive price and this in turn implies they do not need to produce at their allocatively efficient levels, rather they will produce at a level that MAXIMISES PROFITS, which you will soon see means that they will ALWAYS PRODUCE at a level BELOW THEIR EFFICIENT LEVEL, and hence UNDERPRODUCE.
But is it realistic to believe that a firm will always price at the equilibrium price? For this to occur we are making some very UNREALISTIC ASSUMPTIONS that rarely apply in the real world.
To illustrate these inaccurate assumptions imagine that we had a supply and demand diagram showing the market for IBDP schools in Singapore. For this to be an accurate we are assuming the following about OFS:-
There is a SINGLE PRICE CHARGED for all IBDP courses by all Singapore-based international schools. NOT TRUE!
If OFS was to RAISE ITS PRICE above this level, 100% of CUSTOMERS WOULD LEAVE to go to a rival school, that offers a PERFECT SUBSTITUTE. NOT TRUE!
OFS is UNABLE TO DISTINGUISH ITSELF in any way whatsoever from its rivals in the eyes of customers (e.g through location, design, facilities, marketing etc...) and thus they PRODUCE COMPLETELY IDENTICAL PRODUCTS. NOT TRUE!
OFS is just ONE OF THOUSANDS OF SMALL-SCALE SUPPLIERS of the IBDP in Singapore with no ability to grow in size and therefore HAS NO IMPACT ON THE OVERALL MARKET SUPPLY. NOT TRUE!
New schools freely ENTER the market whenever demand increases and EXIT the market when demand decreases. NOT TRUE!
With reference to the example above, our models so far are all assuming that there is PERFECT COMPETITION between all firms and that they are just one of MANY SMALL COMPETING FIRMS, that are all PRODUCING IDENTICAL (HOMOGENOUS) PRODUCTS and therefore have to TAKE THE COMPETITIVE MARKET PRICE, (Hence they HAVE NO PRICE SETTING ABILITY or in other words MARKET POWER)
Diagrammatically this implies each firm faces a PERFECTLY ELASTIC DEMAND CURVE, placed at the market price.
--MARKET-- --FIRM--
However, in reality, almost ALL FIRMS HAVE SOME MEANS OF DIFFERENTIATING ITSELF FROM THEIR RIVALS, such as location, branding, customer services, etc that ACT AS BARRIERS TO COMPETITION and in extreme cases such as monopolies result in only one firm in the market, hence as the price is raised they do not lose all (if any) customers. For example why can your local 7-11 charge $3 for a coke, while it costs only $2 if you drive to the TESCO supermarket?"
With price-setting ability, each firm naturally faces a unique DOWNWARD SLOPING DEMAND CURVE the SLOPE of which DEPENDS ON ITS ELASTICITY which is in turn determined by the closeness of its substitutes.
You will soon see that having any firm that faces a downward sloping demand curve will ALWAYS result in UNDERPRODUCTION and hence a MARKET FAILURE.
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