Question

what is the underlying assumptions of each of the 4 major market structures and how perfect competion compares to the others in terms of price and output.

Answer 1

The features of perfect competition are:

(a) Large Number of Sellers and Buyers: The number of buyers and sellers are large. No buyer or seller can influence the price. The producers are price takers.

(b) Products are identical. The products are homogeneous.

(c) Perfect information. The buyers have perfect information about the products being sold and prices charged.

(d) Perfect mobility of resources like labor

(e) Entry and exit from the industry happens freely.

Features of pure monopoly are:

1. Monopolies generally have one seller and many consumers.

2. There are no close substitutes.

3. The infrastructure and research and developmental costs are very high, the industry has increasing returns to scale, presence of natural resources.

4. There are barriers to entry.

5. The monopolist is a price maker.

6. The monopolist practices price discrimination, i.e., selling the same good to different groups of customers at different prices.

Monopolistic competition is characterized by:

1. Large number of sellers

In monopolistic competition the number of sellers is large and no one seller can influence the price much. The products sold are close substitutes. No seller can dictate terms in the market. Collusion among firms is impossible. Each firm is a price maker.

2. Differentiated products

The products are differentiated. The differentiation can be due to the physical properties of the product. Differentiation can also be on the basis of location of the product, advertising, pricing, services provided.

3. Free entry and exit of firms. There are low barriers to entry and exit.

4. Monopolist competitive firms face a downward sloping demand curve which is elastic. It can sell more goods only by lowering the price. Profit maximization occurs at the intersection of MR and MC.

Oligopoly

1. Few sellers. Oligopoly firms are few.

2. Firms are mutually dependent. Action of one firm affects the other firms.

3. There are barriers to entry due to the huge capital costs.

4. Oligopoly is marked by non-price competition.

5. The products can be standardized or differentiated.

6. There is a lot of collusion between the oligopoly firms.

In the long run, a competitive firm is in equilibrium when MR=MC=AC. It will produce that output where LMC=LAC. Because if P is less than AC, the firm is suffering a loss. Perfectly competitive firm is a price takers and faces a horizontal demand curve which is highly elastic.

Long term equilibrium of the perfectly competitive firm promotes allocative and productive efficiency. There is no deadweight loss in perfect competition. Allocative efficiency means P=MC. Price is the willingness to pay by a consumer, which is the social benefit. MC is the cost to the producer, which is the social cost of producing the good. Allocative efficiency occurs when social benefit equals social cost. Allocative efficiency means that resources are used most efficiently in an economy.

Productive efficiency occurs in perfect competition, because P=minimum ATC. This means the goods are produced at the lowest cost. When a firm is producing at the lowest minimum ATC then the firm is earning normal profits. If P> minimum ATC, then firm is making economic profit and other firms will enter the industry. If P< minimum ATC, then the firm is incurring a loss in the long run. Firms will exit the industry.

In oligpoly, monopoly and monopolistic competition, marginal cost is less than price. There is no allocative efficiency and, also, products are not produced at the minimum ATC. There is no productive efficiency. These market structures face a downard sloping demand curve. Which means more products can be sold when price is reduced. These are price makers. The profit maximization price is higher than that of a perfectly competitive firm and output is lower than that of a perfectly competitive firm. There is deadweight loss.