MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency

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Introduction to Economics ECO401

UNIT - 6

Lesson 6.1

MARKET STRUCTURES

Market structure refers to how an industry (broadly called market) that a firm is operating in is

structured or organized.

The key ingredients of any market structure are:

· Number of firms in the market/industry

· Extent of barriers to entry

· Nature of product

· Degree of control over price.

Knowledge about market structure can help answer four questions:

i. How much profit a firm will make (normal or supernormal)

ii. How much quantity it will produce at its profit-maximisation point (i.e. whether it will

be a large level of output or a small one relative to the market)

iii. Whether or not a higher level of output would increase the cost or productive

efficiency of the firm or allocative efficiency for society (see the summary on

monopoly for details)

iv. Are the prices set too high, too low, or just right?

Four broad market structures have been identified by economists:

· Perfect competition

· Monopoly

· Monopolistic competition

· Oligopoly.

Implication for

Type of

Number Freedom of

Nature of

Examples

demand curve of

market

of firms

entry

product

firm

Perfect

Very

Homogenous

Grains (wheat) or Horizontal; firm is a

Unrestricted

competition

many

(undifferentiated) vegetables

price taker

Downward sloping but

Monopolistic Many /

Plumbers,

relatively elastic; firm

Unrestricted Differentiated

competition Several

restaurants

has some control over

prices.

Downward sloping

relatively inelastic but

Cement, cars,

Oligopoly or

Undifferentiated

depends on reactions

electrical

Few

Restricted

or 2.

Cartel

of rivals to a price

appliance, oil.

Differentiated

change

Downward sloping

Restricted or

more inelastic than

WAPDA, or

Monopoly

One

completely Unique

oligopoly; firm has

KESC

blocked

considerable control

over price

Introduction to Economics ECO401

PERFECT COMPETITION

The main assumptions of perfect competition are:

i. Large number of buyers and sellers, therefore firms price-takers.

ii. No barriers to entry (also implies free mobility of factors of production).

iii. Identical/homogeneous products.

iv. Perfect information/knowledge.

The word perfect in perfect competition is not used its normative sense. Rather it means that

competition in the industry is of an extreme nature. It is used as a benchmark with which to

compare other types of market structures.

Perfect competition can be thought of as an extreme form of capitalism, i.e. all the firms are

fully subject to the market forces of demand and supply.

Concentration ratio is used to assess the level of competition in an industry. It is simply the

percentage of total industry output that is produced by the 5 largest firms in the industry.

The Short Run and Long Run under Perfect Competition:

The short run is the period where at least one factor of production is fixed. In perfect competition,

it also means that no new firms can enter the market. In the long run, all the factors of production

are variable.

Equilibrium analysis can help us answer questions about the market-clearing price and quantity;

where the profits are maximized and how much are these profits; how individual firms make their

short run supply decisions and how these translate into the long-run industry supply curve.

In the short run, a perfectly competitive firm can settle at an equilibrium where it is making super

normal profits, normal profits, loss, or where it decides to shut down.

In the short run, the firm's supply curve is identical to the positive part of MC. The short run

industry supply curve is simply the horizontal summation of the supply curves of individual firms.

The demand (or AR) curve for the industry is downward sloping but for any individual perfectly

competitive firm, is horizontal. Thus the firm can sell as much at the given market price. For this

reason, the AR and MR curves align under perfect competition.

In the long run, any firm can enter or leave the industry. If there are supernormal profits in the

short run, more firms will be attracted to the market and the increase in supply will push prices

down to eliminate supernormal profit possibilities in the long run. By contrast, if firms are making

losses in the short run, they will leave the industry in the long run causing supply to fall, prices to

rise and normal profitability to be restored. In the long run, therefore, perfectly competitive firms

can only earn normal profits.

Allocative Efficiency and Productive Efficiency:

Public interest is concerned with both allocative efficiency and productive efficiency.

a. Allocative efficiency: The optimal point of production for any individual firm is where

MR=MC. The optimal point of production for any society is where price is equal to

marginal cost. This is called the point of maximum allocative efficiency and is achieved

in perfect competition (because MR=MC, and MR=AR=P for a perfectly competitive price

taking firm, therefore P=MC).

b. Productive efficiency: This is attained when firms produce at the bottom of their AC

curves, that is, goods are produced in the most cost efficient manner. Perfectly

competitive firms also achieve this in the long run because they produce at P=MC and

this intersection point also happens to be the point of tangency with the lowest part of the

AC curve. Thus P= ACminimum.

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